Assignment on Glossary related to Macroeconomics terminologies

AEC-01M-2022
Sawan Rajbanshi

1. Macroeconomics
Macroeconomics is concerned with the analysis of the behavior of the economic system in
totality. Thus, macroeconomics studies how the large aggregates such as total employme nt,
national product or national income of an economy and the general price level are
determined. Macroeconomics is therefore a study of aggregates. Besides, macroeconomics
explains how the productive capacity and national income of the country increase over time
in the long run. Macroeconomics is the branch of economics that studies the behavior and
performance of an economy as a whole. It focuses on the aggregate changes in the economy
such as unemployment, growth rate, gross domestic product and inflation.
Macroeconomics analyzes all aggregate indicators and the microeconomic factors that
influence the economy. Government and corporations use macroeconomic models to help
in formulating of economic policies and strategies. Professor Gardner Ackley makes the
distinction between macroeconomics and microeconomics more clearly when he says,
"Macroeconomics concerns itself with such variables as the aggregate volume of the output
of an economy with the extent to which its resources are employed, with the size of the
national income, with the general price level". Microeconomics, on the other hand, deals
with the division of total output among industries, products and firms and the allocation of
resources among competing uses.
It is evident from above that the subject matter of macroeconomics is to explain what
determines the level of total economic activity (that is, the size of the national income and
employment) and fluctuations (ie., ups and downs) in it in the short run. It also explains
what causes the general price level to rise and determines the rate of inflation in the
economy. Besides, modern macroeconomics analyses those factors which determine the
increase in productive capacity and national income in the long run. The problem of
increasing productive capacity and national income over time in the long run is called the
problem of economic growth. Thus, what determines rate of growth of an economy is also
the concern of macroeconomics. Thus, why is national income higher today than it was in
1950? Why does rate of unemployment in a free market economy go up in a period and
fall in another period? Why do some countries have high rates of inflation, while others
maintain price stability? What causes alternating periods of depression and boom
(generally described as business cycles)? Why government should intervene in the
economy and what policy it should adopt to check inflation, control business cycles, raise
level of national income, reduce unemployment and restore equilibrium in the balance of
payments are some of the important questions which macroeconomics seeks to answer.
2. Stock variable :
A stock is a quantity which is measurable at a particular point of time, e.g., 4 p.m., 1st
January, Monday, 2010, etc. Capital is a stock variable. ... Examples of stocks are: wealth,
foreign debts, loan, inventories (not change in inventories), opening stock, money supply
(amount of money), population, etc. Stock represents the quantity at certain point of time
whereas the flow variable represents the quantity at certain interval of time. For more
clearification between stocks and variable following points may be helpful:
• Thus, a stock refers to the value of an asset at a balance date, while a flow refers to the
total value of transactions during an accounting period.
• Gross domestic product refers to number of dollars spent over a period of time so it is
flow variable whereas stock variable refers to capital stock at a certain point of time.
• Stocks and flows have different units and are thus not commensurable – they cannot be
meaningfully compared, equated, added, or subtracted. However, one may meaningfully
take ratios of stocks and flows, or multiply or divide them.

An easy way to distinguish between flow and stock variables is that a flow variable is
measured over a period of time while stock variable is measured at a specific point of time.
If someone asked you, “How much water flowed into the bathtub on September 4 at 4:40pm
and 10 seconds?” it would be very difficult to answer because it is difficult to measure the
amount of water flowing at a specific second.However, if someone asked, “How much
water was in the bathtub on September 4 at 4:40pm and 10 seconds?” it would be quite
easy to answer (given that you had some tool to measure the level of water). This is because
the water level is a stock variable. A stock variable is measured at a point in time and
“September 4, at 4:40pm and 10 seconds” is a point in time.On the other hand if someone
asked “How much water flowed into the bathtub between September 4 between 4:40pm
and 4:50pm?” you would also be able to answer it, because you are now given a “period
of time” (a period of 10 minutes) and flow variables are measured over a period.

3. Flow variable :
A flow is a quantity which is measured with reference to a period of time. Thus, flows are
defined with reference to a specific period (length of time), e.g., hours, days, weeks, months
or years. It has time dimension. National income is a flow. It describes and measures flow
of goods and services which become available to a country during a year. Similarly, all
other economic variables which have time dimension, i.e., whose magnitude can be
measured over a period of time are called flow variables. For instance, income of a person
is a flow which is earned during a week or a month or any other period. Likewise,
investment (i.e., addition to the stock of capital) is a flow as it pertains to a period of time.
Other examples of flows are: expenditure, savings, depreciation, interest, exports, imports,
change in inventories (not mere inventories), change in money supply, lending, borrowing,
rent, profit, etc. because magnitude (size) of all these are measured over a period of time.
Personal consumption is a flow variable that measures the value of goods and services
purchased by households during a time period. Purchases by households of groceries,
healthcare services, clothing, and automobiles—all are counted as consumption. A flow
shows change during a period of time whereas a stock indicates the quantity of a variable
 at a point of time. Thus, wealth is a stock since it can be measured at a point of time, but
income is a flow because it can be measured over a period of time. The distinction between
flows and stocks can be easily understood by comparing the actions of Still Camera (which
records position at a point of time) with that of Video Camera (which records position
during a period of time).(Singh, null) A stock (or "level variable") in the broader sense is
some entity that is accumulated over time by inflows and/or depleted by outflows. Stocks
can only be changed via flows. Mathematically a stock can be seen as an accumulation or
integration of flows over time – with outflows subtracting from the stock. Stocks typically
have a certain value at each moment of time – e.g. the number of population at a certain
moment, or the quantity of water in a reservoir. A flow (or "rate") changes a stock over
time. Usually we can clearly distinguish inflows (adding to the stock) and outflows
(subtracting from the stock). Flows typically are measured over a certain interval of time –
e.g., the number of births over a day or month.

4. Ratio variable:
A variable with the features of interval variable and any two values of it has meaningf ul
ratio, making the operations of multiplication and division meaningful. There is always an
absolute zero in case of ratio variable. Weight is a ratio variable. In applied social research
most "count" variables are ratio variables. The ratio variable is one of the 2 types of
continuous variables, where the interval variable is the 2nd. It is an extension of the interva l
variable and is also the peak of the measurement variable types. The only differe nce
between the ratio variable and interval variable is that the ratio variable already has a zero
value. For example, temperature, when measured in Kelvin is an example of ratio variables.
The presence of a zero-point accommodates the measurement in Kelvin. Also, unlike the
interval variable multiplication and division operations can be performed on the values of
a ratio variable. Ratio variables have absolute zero characteristics. The zero point makes is
what makes it possible to measure multiple values and perform multiplication and divisio n
operations. Therefore, we can say that an object is twice as big or as long as another. It has
an intrinsic order with an equidistant scale. That is, all the levels in the ratio scale has an
equal distance. Due to the absolute point characteristics of a ratio variable, it doesn’t have
a negative number like an interval variable. Therefore, before measuring any object on a
ratio scale, researchers need to first study if it satisfies all the properties of an interva l
variable and also the zero point characteristic. Ratio variable is the peak type of
measurement variable in statistical analysis. It allows for the addition, interactio n,
multiplication, and division of variables. Also, all statistical analysis including mean,
mode, median, etc. can be calculated on the ratio scale. The ratio variable, on the other
hand, is the most complicated of the measurement variables and may thus be used to
undertake the most complicated analysis. Even so, it’s possible that it’ll be very
complicated at times, and one of the other variable types will be a better choice. Some of
the examples are variables like GDP or government consumption
5. Dynamic equilibrium:
In economic sense, equilibrium refers to a state or situation in which opposite economic
forces, e.g., demand and supply, are in balance and there is no in-built tendency to deviate
from this position. At macro level, an economy is said to be in equilibrium when aggregate
demand equals aggregate supply. Aggregate demand is the sum of demand for all
consumers and capital goods and services, given the aggregate demand for money.
Aggregate supply is the sum of the supply of all consumer and capital goods and services,
given the aggregate supply of money. As long as equilibrium is not disturbed by interna l
or external disequilibrating factors, the economy remains in equilibrium. Dynamic
approach is adopted to study an economy in motion. When a macroeconomics phenomenon
is analyzed under changing or dynamic conditions, it is called dynamic equilibr ium
analysis. Dynamic analysis is adopted to study an economy under dynamic conditions. In
a dynamic economy, the economic factors and forces keep changing. The merit of dynamic
analysis lies in its power to predict the future course of the economy. A static analysis, by
its very nature has no power to predict the path a dyanamic economy follows while moving
from one equilibrium point to another, nor it can be used to predict whether the economy
will ever attain another equilibrium position. Dynamic approach does the job. Economic
dynamics studies the factors and forces that set economy in motion and lead it to a new
equilibrium at a higher or lower level. It studies the action of, and interactions between, the
factors and forces of change. The interaction between the factors and forces of change is
not instantaneous and simultaneous. It involve a time-lag i.e. the time that a change in any
economic variable takes to affect the other related variables, and the time that other
variables take to adjust themselves to the change. Dynamic analysis takes into account the
time lag involved in the process of adjustments. It studies the nature and magnitude of
changes and finds whether they are oscillatory or dampening- if oscillatory, then whether
divergent or convergent. If they are convergent, the economy may reach another
equilibrium. If changes are divergent, the economy may not attain another equilibr ium
position-it may keep oscillating constantly.

6. Static equilibrium:
The word equilibrium is derived from the Latin word aequilibrium which means equal
balance use in economics is imported from physics. In economics, equilibrium implies a
position of rest characterized by absence of change. In basic supply and demand model,
equilibrium is where quantity demanded and quantity supplied are equal. No agent in the
system has an incentive to change its behaviour. In static equilibrium factors or input will
not change. For example, demand and supply will remain constant. All parties involved are
achieving maximum gratification. An economic analysis that limits its attention to the final
equilibrium position is called statics.
A static model may be simple, comprehensive and irrespective of its type, it merely
strengthens in the equilibrium spot “According to Prof.Mehta”. “Static equilibrium is that
equilibrium which maintains itself outside the period of time under consideration”. It is
state of bliss which every individual firm, industry or factor wants to attain and once
reached, would not like to leave. Consumer is in equilibrium when he gets maximum
satisfaction from a given expenditure on different goods and services. Any move on this
part to reallocate his expenditure among his purchases will decrease rather than increase
his total satisfaction. A firm is in equilibrium when its profit is the maximum and it has no
incentive to expand or contract its output. It is a position in which neither the adjusting
firms have any tendency to live nor few firms to enter the industry. In other words, an
industry is in equilibrium when all firms are earning only normal profits.
Static equilibrium is of 3 types and they are:
• Micro static
• Macro static
• Comparative static

Micro static: In the micro static models of price determination, supply and demand
relationship determine price at a point of time which are also constant through time. The
given demand and supply functions are:
D = (P)...... (1)
S= (P) ........... (2)
Where, D = demand , P= price and S= supply
The equation 1 shows that demand is inversely proportional to price i.e. if price decrease
the demand will rise and if price increases, the demand will fall keeping other things
constant.
On the other hand equation 2 shows that supply is also the function of price i.e. if price
increase supply will rise and if price decrease supply will fall, other things remaining
constant.
From equations 1 and 2,
D = S........... (3)

Macro- static:
Macro static is concerned with the study of relationship between different macro economic
variables such as total consumption, total income and total investment in the state of
equilibrium representing a particular point of time. The concept of Macro- static explains
the static equilibrium position of the economy.
This concept is best explained by Prof. Kurihara “if the object is to show a still picture of
the economy as a whole, the macro-static method is the appropriate technique. This
technique is one of investigating the relations between macro-variables in final position of
equilibrium without reference to the process of adjustment implicit in that final position”.
Such a final position of equilibrium may be shown by the equation Y= C+ I
Where, Y= Total income C= Total consumption expenditure I= Total investme nt
expenditure

Comparative static:
A comparative static analysis compares one equilibrium position with another when data
have changed and system has finally reached another equilibrium position. It does not show
how the system has reached the final equilibrium position with a change in data. It merely
explains and compares the initial equilibrium position with the final one reached after the
system has adjusted to a change in data. In Comparative macroeconomics. We compare
two static macro equilibriums or two different equilibrium positions representing two
 different points of time. Thus, in comparative static analysis, equilibrium positions
corresponding to different sets of data are compared.
Limitations of Comparative Statics Analysis
• It fails to predict the path which the market follows when moving from one equilibr ium
position to another.
• It cannot predict whether or not a given equilibrium position will ever be achieved.

7. Technical relationship
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 AEC-02M-2022
Dinesh Paudel

Functional relationship

We frequently need to represent economic quantities as a mathematical function of one or more

variables,
e.g.: A firm’s costs as a function of output
Market demand for a good in terms of price and other factors
A consumer’s utility in terms of quantities of different goods purchased.
A function is a rule that takes one or more numbers as inputs (arguments) and gives another number
as output.
Functional relation refers to the effect of an independent variable on a dependent variable. An
independent variable is something that is manipulated to effect a change in another variable (a
dependent variable). If changes in the independent variable result in changes in the dependent
variable, then there is a functional relation between the two variables.
A function is a relation in which each possible input value leads to exactly one output value.
How to determine which relationship is function?
-Identify the input values.
-Identify the output values.
-If each input value leads to only one output value, the relationship is a function. If any
input value leads to two or more outputs, the relationship is not a function.
For example, think about the function y = 3 - x. Here's a table showing some input and output
values of that function:
Input x Output y

1 2

2 1
3 0

4 -1

5 -2

For every 1-unit increase in x, there is a 1-unit decrease in y. It is a functional relationship between
two sets of quantities.
We can also describe functional relationship by using graph. If we see a graph where the line is
slanting up from left to right, it means that the function is increasing; in other words, as x increases,
y increases. If you see a graph where the line is slanting down from left to right, it means the
opposite: the function is decreasing, or as x increases, y decreases. If the graph is a straight line,
the rate of change is constant. If the graph is curved, the rate is changing. If you have a changing
rate, if the graph is getting steeper, then the rate of change is increasing. If it's getting flatter, the
rate of change is decreasing.

Behavioral relationship
Behavioral relationship refers to the thing that tell us how people will change their behavior to
respond to changes in the economic environment and economic policy.
What exactly is meant by “behavioral macroeconomics” is not easy to define. In his Nobel prize
Lecture “Behavioral macroeconomics and macroeconomic behavior”, Akerlof (2002) uses a
very broad definition that includes models of asymmetric information, maintaining the assumptio n
of rational expectations, to explain market failures. In a recent survey Driscoll & Holden (2014)
summarize and discuss several concepts that behavioral economics has brought to macro-models,
such as fairness considerations and other regarding social preferences, cognitive biases, hyperbolic
discounting of consumption and savings, habit formation and rule-of-thumb consumption. De
Grauwe (2012) in his Lectures on Behavioral Macroeconomics emphasizes boundedly rational
heterogeneous expectations in the New Keynesian macro- model, where agents switch between
simple forecasting heuristics based upon their relative performance as in Brock & Hommes (1997).
There are thus many possible deviations –large or small– from the benchmark rational model. In
the traditional macroeconomic paradigm, there are (at least) three crucial assumptions:
 i.agents have rational expectations;
ii.agents behave optimal, i.e., maximize utility, profits, etc. and; related to both,
iii.agents have an infinite horizon for optimization and expectations. A pragmatic (but still
admittedly subjective) definition of behavioral macroeconomics would be that (at least) one
of these assumptions is relaxed.

Conventional economics assumes that all people are both rational and selfish. In practice, this is
often not the case, which leads to the failure of traditional models. Behavioral economics studies
the biases, tendencies and heuristics that affect the decisions that people make to improve, tweak
or overhaul traditional economic theory. It aids in determining whether people make good or bad
choices and whether they could be helped to make better choices. It can be applied both before
and after a decision is made. Behavioral Economics is the study of psychology as it relates to the
economic decision-making processes of individuals and institutions. The two most important
questions in this field are:
Are economists' assumptions of utility or profit maximization good approximations of real people's
behavior?
Do individuals maximize subjective expected utility?
Understanding Behavioral Economics
In an ideal world, people would always make optimal decisions that provide them with the greatest
benefit and satisfaction. In economics, rational choice theory states that when humans are
presented with various options under the conditions of scarcity, they would choose the option that
maximizes their individual satisfaction. This theory assumes that people, given their preferences
and constraints, are capable of making rational decisions by effectively weighing the costs and
benefits of each option available to them (Simon, 1987). The final decision made will be the best
choice for the individual. The rational person has self-control and is unmoved by emotions and
external factors and, hence, knows what is best for himself. Alas behavioral economics explains
that humans are not rational and are incapable of making good decisions.

Applications
One application of behavioral economics is heuristics, which is the use of rules of thumb or mental
shortcuts to make a quick decision (Thaler, 2016). However, when the decision made leads to
error, heuristics can lead to cognitive bias. Behavioral game theory, an emergent class of game
theory, can also be applied to behavioral economics as game theory runs experiments and analyzes
people’s decisions to make irrational choices. Another field in which behavioral economics can be
applied to is behavioral finance, which seeks to explain why investors make rash decisions when
trading in the capital markets.
Companies are increasingly incorporating behavioral economics to increase sales of their products.
Consider a soap manufacturer who produces the same soap but markets them in two differe nt
packages to appeal to multiple target groups. One package advertises the soap for all soap users,
the other for consumers with sensitive skin. The latter target would not have purchased the product
if the package did not specify that the soap was for sensitive skin. They opt for the soap with the
sensitive skin label even though it’s the exact same product in the general package. As companies
begin to understand that their consumers are irrational, an effective way to embed behavioral
economics in the company’s decision-making policies that concern its internal and external
stakeholders may prove to be worthwhile if done properly.

Equilibrium relationship/ identity relationship

In economic sense, equilibrium refers to a state or situation in which opposite economic
forces, e.g., demand and supply, are in balance and there is no in-built tendency to deviate from
this position.
At macro level, an economy is said to be in equilibrium when aggregate demand equals aggregate
supply. Aggregate demand is sum of demands for all consumer and capital goods and services,
given the aggregate demand for money. Aggregate supply is sum of the supply of all consumer
and capital goods and services, given the aggregate supply of money. As long as equilibrium is
not disturbed by internal or external disequilibrium factors, the economy remains in equilibr ium.
The total demand for goods and service ina n economy during a specific period of time is called
aggregate demand. The total economic output of goods and services in an economy at a certain
time period is known as aggregate supply. For instance, aggregate supply is the total amount of
lemonade made during a specific time. Factors such as labor, capital, natural resources, and
technology affect aggregate supply in the long run.
For example, if the aggregate demand for your lemonade is too low, then your new business
venture won't need to keep making as much lemonade and if you hired any friends to help you run
your lemonade stand, you may have to let them go. This is because if customers are not buying
lemonade, you won't be making money, which means you won't be able to pay any of your friends.
When this happens at large companies, workers are often laid off, which ultimately causes the
unemployment rate to increase.

Economic Model
In economics, a model is a theoretical construct representing economic processes by a set
of variables and a set of logical and/or quantitative relationships between them. The
economic model is a simplified, often mathematical, framework designed to illustrate complex
processes. Frequently, economic models posit structural parameters. A model may have
various exogenous variables, and those variables may change to create various responses by
economic variables. Methodological uses of models include investigation, theorizing, and fitting
theories to the world.
A model establishes an argumentative framework for applying logic and mathematics that can be
independently discussed and tested and that can be applied in various instances. Policies and
arguments that rely on economic models have a clear basis for soundness, namely the validity of
the supporting model.
Economic models in current use do not pretend to be theories of everything economic; any such
pretensions would immediately be thwarted by computational infeasibility and the incomplete ness
or lack of theories for various types of economic behavior. Therefore, conclusions drawn from
models will be approximate representations of economic facts. However, properly constructed
models can remove extraneous information and isolate useful approximations of key relationships.
In this way more can be understood about the relationships in question than by trying to understand
the entire economic process.
A macroeconomic model is an analytical tool designed to describe the operation of the problems
of economy of a country or a region. These models are usually designed to examine the
comparative statistic and dynamics of aggregate quantities such as the total amount of goods and
services produced, total income earned, the level of employment of productive resources, and the
level of prices.
Macroeconomic models may be logical, mathematical, and/or computational; the different types
of macroeconomic models serve different purposes and have different advantages and
disadvantages. Macroeconomic models may be used to clarify and illustrate basic theoretical
principles; they may be used to test, compare, and quantify different macroeconomic theories; they
may be used to produce "what if" scenarios (usually to predict the effects of changes
in monetary, fiscal, or other macroeconomic policies); and they may be used to generate economic
forecasts. Thus, macroeconomic models are widely used in teaching and research, and are also
widely used by international organizations, national governments and larger corporations, as well
as by economic consultants.
Types of economic models:
Simple theoretical models:
Simplification is particularly important for economics given the enormous complexity of economic
processes. This complexity can be attributed to the diversity of factors that determine economic
activity; these factors include: individual and cooperative decision processes, resource limitatio ns,
environmental and geographical constraints, institutional and legal requirements and purely
random fluctuations. Economists therefore must make a reasoned choice of which variables and
which relationships between these variables are relevant and which ways of analyzing and
presenting this information are useful.
Simple textbook descriptions of the macroeconomy involving a small number of equations or
diagrams are often called models. Some examples are: IS-LM model, Mundell-Fleming model etc.
Empirical forecasting models:
These models estimated the relations between different macroeconomic variables using time
series analysis.
National income
In macroeconomics, national income refers to the total amount of money made in a country during
a given period of time. It includes traditional income (earned by an individual from a job), rent
capital earned from the lease of land or buildings and money made by private corporations. The
change in national income from year to year is an important indicator of how well the national
economy is doing. Estimating national income is an extremely complex and vague task. Differe nt
kinds of national income measures are used in national income analysis and in income policy
formulations.
National income can be measured through
Gross Domestic Product
Gross National Product
Net National Product
Personal income

The basic approach in measuring national income is to measure the two kinds of flows generated
by the economic activities of the residents of the country. From the circular flows of income, the
income generating process creates the two kinds of flows.
Product flows
Money flows
Money flows can be looked upon from two angles
Money flows as factor payments
Money flows as payments for goods and services

Economists have devised three methods of measuring the national income.

Net product method or the Value Added Method
Factor Income Method
Expenditure Method

Gross Domestic Product

Gross domestic product (GDP) is a monetary measure of the market value of all the final goods
and services produced and sold (not resold) in a specific time period by countries. GDP definitio ns
are maintained by a number of national and international economic organizations.
Definition: GDP is the final value of the goods and services produced within the geographic
boundaries of a country during a specified period of time, normally a year. GDP growth rate is an
important indicator of the economic performance of a country.
Description: It can be measured by three methods, namely,

1. Output Method: This measures the monetary or market value of all the goods and services
produced within the borders of the country. In order to avoid a distorted measure of GDP due to
price level changes, GDP at constant prices o real GDP is computed. GDP (as per output method)
= Real GDP (GDP at constant prices) – Taxes + Subsidies.

2. Expenditure Method: This measures the total expenditure incurred by all entities on goods and
services within the domestic boundaries of a country. GDP (as per expenditure method) = C + I +
G + (X-IM) C: Consumption expenditure, I: Investment expenditure, G: Government spending
and (X-IM): Exports minus imports, that is, net exports.

3. Income Method: It measures the total income earned by the factors of production, that is, labour
and capital within the domestic boundaries of a country. GDP (as per income method) = GDP at
factor cost + Taxes – Subsidies.

In the latest reports, Nominal GDP of Nepal reached 40.1 USD bn in Jul 2022.
• Its GDP deflator (implicit price deflator) increased 6.3 % in Jul 2022.
• GDP Per Capita in Nepal reached 1,372.0 USD in Jul 2022.
• Its Gross Savings Rate was measured at 31.7 % in Jul 2022.
• For Nominal GDP contributions, Investment accounted for 37.3 % in Jul 2022.
• Public Consumption accounted for 8.2 % in Jul 2022.
• Private Consumption accounted for 82.5 % in Jul 2022.

Gross National Product

GNP is known as gross national product and represents the total value of goods and services
produced by the residents of a country during a financial year.
It takes the income earned by the citizens of the country present within or outside the country into
consideration. It excludes the income generated by the foreign nationals who are residing in the
country. It can be calculated as:
GNP = GDP + NR – NP
Where,
GDP = Gross domestic product
NR = Net income receipts
NP = Net outflow to foreign assets

Gross national product (GNP) refers to the total value of all the goods and services produced by
the residents and businesses of a country, irrespective of the location of production.
GNP takes into account the investments made by the businesses and residents of the country, living
both inside and outside the country. GNP does not take into consideration the incomes earned by
the foreign nationals in the country or any products produced by a foreign company in the
manufacturing units in the country.
For calculating GNP, only the final goods and services are considered. Intermediate goods are
avoided as it leads to double counting.
To calculate the GNP for a nation, the following factors are considered:
Consumption expenditure
Investment
Government expenditure
Net exports (Total exports minus total imports)
Net income (Income earned by residents in foreign countries minus income earned by foreigners
in the country)

The mathematical formula for calculating GNP is expressed as follows: Y = C + I + G + X + Z

Or

GNP = Consumption expenditure + Investment + Government expenditure + Net exports + Net

income
GNP considers the manufacturing of goods like equipment, machinery, agricultural products,
vehicles as well as some services like consulting, education, and health care.
The cost of providing the services is not calculated separately as it is included in the price of the
final products.
GNP per capita is used for the calculation of GNP on a country-to-country comparison, while it
becomes problematic when a citizen holds a dual citizenship. In that case, their income is
contributed as GNP for each of the respective countries, which leads to double counting.

Importance of GNP
GNP is considered as an important economic indicator by economists. It is used by them for
finding solutions to the economic issues such as poverty and inflation.
When income is calculated on the basis of per person irrespective of the location, GNP becomes a
much more reliable factor than GDP.

Drawbacks of GNP
The foreign exchange rate fluctuates. Therefore, it impacts the calculation.
It does not help in determining whether an economy is actually growing or shrinking. This
concludes the important concept of GNP, which is one of the indicators of economic health of a
nation.

GDP GNP

Definition

The value of goods and services produced The value of goods and services produced by the
within the geographical boundaries of a citizens of a nation irrespective of the
nation in a financial year is termed as GDP. geographical limits in a financial year is known as
GNP.

What Does It Measure?

It measures only the domestic production. It measures only the national production.

Emphasis

It emphasises on the production that is It emphasises on the production that is achieved

obtained domestically. by the citizens living in different nations.

Highlights

It highlights the strength of the country’s It highlights the contribution of the residents to
economy. the development of the economy

Scale of Operations

Local scale International scale

Excludes

The goods and services that are being The goods and services that are produced by the
produced outside the economy are foreigners living in the country are excluded.
excluded.
 AEC-03M-2022
Pragya Paudel
Depreciation
Economic depreciation is a measure of the decrease in the market value of an asset over time from
influential economic factors. This form of depreciation usually pertains to real estate, which can
lose value for several reasons such as the addition of unfavorable construction in close proximity
to a property, road closures, a decline in the quality of a neighborhood, or other negative influences.
Economic depreciation is different from accounting depreciation. In accounting depreciation, an
asset is expensed over a specific amount of time, based on a set schedule. Depreciation in
economics is a measure of the amount of value an asset loses from influential factors affecting its
market value. Asset owners may more closely consider economic depreciation over accounting
depreciation if they seek to sell an asset at its market value. Economic depreciation affects the
selling value of an asset in the market. It may be followed and tracked by asset owners. In business
accounting, economic depreciation is not typically notated on financial statement reporting for
large capital assets since accountants usually use book value as the primary reporting method.
There can be several scenarios where economic depreciation is considered in financial analysis.
Real estate is one of the most common examples but analysts may also consider it in other
situations as well. Economic depreciation can also be a factor in forecasts of future revenues for
goods and services. Depreciation refers to an accounting method used to determine the cost of a
tangible or physical asset over its useful life or life expectancy. It means how much of an asset's
value has been used. Depreciating assets helps companies earn revenue from an asset while
expensing a portion of its cost each year the asset is in use. Not accounting for depreciation can
greatly affect a company's profit. Companies can also depreciate long-term assets for both tax and
accounting purposes.
Methods of Depreciation
The four depreciation methods include straight- line, declining balance, sum-of-the-years' digits,
and units of production.

Straight-Line Depreciation
The straight- line method is the most common and simplest to use. A company estimates an
asset's useful life and salvage value (scrap value) at the end of its life. Depreciation determined by
this method must be expensed in each year of the asset's estimated lifespan. This formula is best
for small businesses seeking a simple method of depreciation.
Depreciation: (cost of asset - salvage value)/useful life

Net National Product (NNP)

Net national product (NNP) is the monetary value of finished goods and services produced by a
country's citizens, overseas and domestically, in a given period. It is the equivalent of gross
national product (GNP), the total value of a nation's annual output, minus the amount of GNP
required to purchase new goods to maintain existing stock, otherwise known as depreciation.
Net national product (NNP) is gross national product (GNP), the total value of finished goods and
services produced by a country's citizens overseas and domestically, minus depreciation.
NNP is often examined on an annual basis as a way to measure a nation's success in continuing
minimum production standards.
Gross Domestic Product (GDP) is the most popular method to measure national income and
economic prosperity, although NNP is prominently used in environmental economics. It can be a
useful method to keep track of an economy as it takes into account all its citizens, regardless of
where they make their money, and acknowledges the fact that capital must be spent to keep
production standards high.
The NNP is expressed in the currency of the nation it represents.
NNP can be calculated as:
NNP=Gross National Product−Depreciation

Per Capita Income

Per capita income is a measure of the amount of money earned per person in a nation or geographic
region. Per capita income is used to determine the average per-person income for an area and to
evaluate the standard of living and quality of life of the population. Per capita income for a nation
is calculated by dividing the country's national income by its population.
Per capita income is a measure of the amount of money earned per person in a nation or geographic
region. Per capita income includes all individuals, not just adults of working age. Per capita income
as a metric has limitations that include its inability to account for inflation, income disparity,
poverty, wealth, or savings.
It is useful because it is widely known, is easily calculable from readily available gross domestic
product (GDP) and population estimates, and produces a useful statistic for comparison of wealth
between sovereign territories. This helps to ascertain a country's development status. It is one of
the three measures for calculating the Human Development Index of a country. Per capita income
is also called average income.
Although per capita income is a reliable and widely used economic metric, it also comes with a
few limitations. Some of these limitations are its instability to account for inflation, poverty,
income disparity, savings or wealth. As per capita income considers the overall income of a
population and divides it by the number of people without taking into account the inequality in
income of people from different parts of the society and different work backgrounds, it cannot
always be considered as an accurate representation of the standard of living or prosperity of a
particular area or nation. This is why per capita income doesn’t really give you a true or clear
picture about the living conditions of all people in a certain area.
per capita income can be calculated by using the following formula:
Per capita income = total income of the population / population
Uses of Per Capita Income
The following are the most popular ways in which per capita is used: - Gross domestic product
(GDP) - Per capita income
GDP Per Capita
GDP per capita is a measurement utilized to determine a country's economic output the number of
people living in the country. The GDP of your country is calculated by dividing the country's total
domestic output by its population. The formula for GDP is as follows: Gross domestic
product/population = GDP per capita
Gross National Income Per Capita
You can also discover the gross national income per capita of a country using a related formula to
the one you used to get the GDP per capita. To determine the gross national income per capita,
you can use the same information used to calculate the GDP, in addition to any income that
residents from foreign investments.
Limitations of Per Capita Income
Just like any other economic or financial tool, per capita income has its own limitations which are
stated as follows: *It does not account for income inequality among the population and hence
cannot be considered to be an accurate measure of the standard of living of people. *It does not
reflect inflation, which is the rate at which the prices rise with time. This affects the purchasing
power of the consumer and limits the increase in income. Due to this happening, per capita income
can possibly overstate a population’s income. *An individual’s personal wealth and savings are
not included in the per capita income. *Children are also included in the calculation of per capita
income even though they don’t earn. This is why countries like India where the number of children
is high may have skewed results of per capita income.

Capital Gains
Capital gain is the increase in a capital asset's price (investment or real estate), which offers
the asset a higher value than the purchase price. Until the asset is sold, the gain is not realised.
A capital gain can be either be short-term (one year or less) or long-term (more than one year); it
must be reported while filing income taxes.
Although capital gains are generally associated with stocks and funds due to their inherent price
volatility, any security sold at a price higher than the purchase price paid for it may result in a
capital gain. Realised capital gains and losses occur when an asset is sold, and a taxable event is
triggered.
Unrealised gains and losses sometimes referred to as gains and losses on paper, reflect an increase
or decrease in the value of an investment, but have not yet triggered a taxable event. When the
value of a capital asset is reduced as compared to the purchase price of an asset, it is known as a
capital loss.
Assets transformation
Asset transformation is the process of creating a new asset (loan) from liabilities (deposits) with
different characteristics by converting small denomination, immediately available and relative ly
risk-free bank deposits into loans–new relatively risky, large denomination asset–that are repaid
following a set schedule.
Asset transformation can be described into two ways. One is the way of bank and another is in the
way of financial intermediary. Asset transformation by bank is turning liabilities (Deposits) into
assets (Loan). For eg, AB bank issued bond. Then made small pieces. Turn them into loans and
offer them to the market. Asset transformation by financial intermediaries is purchasing primary
asset or securities and transforming them into different asset in terms of risk and maturity date.
The types of asset transformation by a financial institution are maturity transformatio n,
denomination transformation and risk transformation
• A broker borrows funds from many persons for short-term then he purchased a bond with 10-
year maturity. But the persons who deposited money they don't want 10-year maturity. Some want
6 months; some want 3 month and some want 1 year of maturity. So, the broker sliced 10-year
maturity bond into many pieces and sold them to different persons from whom he borrowed
money. This is maturity transformation of asset.
• A broker purchased a 10-million-dollar bond. He can't find people who are interested in buying
a single 10-million-dollar bond. So, he sliced it into different pieces and sold them. The maturity
date is same. This is called denomination transformation of asset.
• A broker purchased a 1-million-dollar bond. People want to buy his bond but not the whole
amount and some want to bear smaller risk and some want to gain more so they are willing to take
more risk. The broker sliced 1 million dollars into smaller pieces and then for some pieces he
declared 5% interest which is risky and for some pieces he declared 2% interest which is not risky.
This is called risk transformation of asset.

Disposable income
Disposable income is the amount of money that individuals and families have available for
spending or saving after they have paid their direct taxes and received any state welfare benefits.
Types of disposable income
Personal Disposable income: It refers to that part of personal income which is actually available
at the disposable of household.
National Disposable Income: It refers to the income which is available to the whole country for
disposable. It is also known as Net National Disposable Income. One of the most important factors
in determining consumer purchasing is disposable income. It's also one of the most significa nt
determinants of demand. The number of products and services that can be acquired at various
prices throughout a given period is referred to as disposable income. It indicates that having a
certain amount of disposable income might influence how much money is spent on products and
services. Disposable income is the source of a number of statistics and economic indicators.
Economists, for example, utilize disposable income to compute metrics like discretionary income,
personal savings rates, marginal propensity to consume (MPC), and marginal propensity to save
(MPS). Discretionary income is disposable income minus all payments for necessities, includ ing
a mortgage or rent payment, health insurance, food, and transportation.
Disposable income= Personal income - (personal income tax+fees+fines)

Double accounting
Double-entry accounting is a system that requires two book entries — one debit and one credit —
for every transaction within a business. Your books are balanced when the sum of each debit and
its corresponding credit equals zero. Contrary to single-entry accounting, which tracks only
revenue and expenses, double-entry accounting tracks assets, liabilities and equity, too.
Principle of Double Entry
Double-entry is based on a simple principle, that for every debit, must have equal and opposite
credit. There should be at least two accounts involved in any transaction.
Debit Side = Credit Side
Advantages
Modern and Scientific: Double entry is a scientific and systematic system of recording and
maintaining books of accounts. There are the Rules and Principles which have to be followed
rigorously.
Complete System of Accounting: This form of accounting records both aspects of a transaction;
hence, it is a complete form of accounting.
Fewer Errors: There are fewer chances of errors as both the debit and credit sides of the transaction
have to be equal.
Fraud Prevention: This accounting system helps in the prevention and early detection of fraud.
Decision Making: A complete set of books helps in decision making for management, investors,
creditors, and auditors.
 AEC-04M-2022
Puja Regmi
Appreciation
Appreciation, in general terms, is an increase in the value of an asset over time. The increase can
occur for a number of reasons, including increased demand or weakening supply, or as a result of
changes in inflation or interest rates. This is the opposite of depreciation, which is a decrease in
value over time. Certain assets are given to appreciation, while other assets tend to depreciate over
time. As a general rule, assets that have a finite useful life depreciate rather than appreciate
• Appreciation is an increase in the value of an asset over time.
• This is unlike depreciation, which lowers an asset’s value over its useful life.
• The appreciation rate is the rate at which an asset grows in value.
• Capital appreciation refers to an increase in the value of financial assets such as stocks.
• Currency appreciation refers to the increase in the value of one currency relative to another
in the foreign exchange markets.
In finance, appreciation is an essential concept. The possibility of an increase in the value of the
asset over time encourages investors to purchase financial assets to earn a profit.
Appreciation can affect different types of assets, including financial assets (e.g., stocks),
currencies, and real estate. It can occur with tangible assets, as well as with intangible assets. For
example, the value of a company’s trademarks can increase due to higher brand recognition among
its customers.

There are several reasons for assets to appreciate or increase in value:

• Increased demand for an asset
• Reduced supply of an asset
• Inflation
• Changes in the interest rate

Effects of Currency Appreciation:

When a nation's currency appreciates, it can have a number of different effects on the economy.
Here are just a couple:
• Export costs rise
• Cheaper imports

How to Calculate the Appreciation Rate

The appreciation rate is virtually the same as the compound annual growth rate (CAGR). Thus,
you take the ending value, divide by the beginning value, then take that result to 1 dividend by
the number of holding periods (e.g. years). Finally, you subtract one from the result. However, in
order to calculate the appreciation rate that means you need to know the initial value of the
investment and the future value. You also need to know how long the asset will appreciate. For
example, Rachel buys a home for $100,000 in 2016. In 2021, the value has increased to
$125,000. The home has appreciated by 25% [($125,000 - $100,000) / $100,000] during these
five years. The appreciate rate (or CAGR) is 4.6% [($125,000 / $100,000)^(1/5) - 1].

Devaluation
A devaluation is a reduction in the value of a country's currency in relation to a foreign currency
or standard. Devaluation is a common monetary policy instrument used by countries with fixed
exchange rates to regulate supply and demand. A devaluation is an indication that the monetary
authority will buy and sell foreign currency at a lower rate.

Pros of devaluation
• To increase exports
• Reduce trade deficits
• To reduce a country's debt costs
Trade imbalances are the fundamental reason why governments depreciate their currencies. They
can lower the cost of a country's exports by devaluing its currency, making it more competitive on
a worldwide basis. Furthermore, as the cost of imports rises, domestic customers are less eager to
buy higher-priced goods from foreign enterprises and prefer to buy cheaper goods locally.
Domestic expenditure would therefore stimulate money circulation inside one's own economy as
a result of the increase in domestic spending. Exports rise due to lower prices, while imports fall
due to perceived higher prices from domestic consumers, resulting in a reduction in trade deficits.
As a result, depreciation of the home currency can help to reduce deficits by increasing demand
for lower-cost exports and higher-cost imports.
Governments may also induce depreciation if they have a high amount of government- iss ued
sovereign debt that is causing economic problems. For example, if the government must pay $2
million in interest every month on its present debt, the nominal interest payments will be reduced
if the currency devalues. In actual dollars, for example, if the currency is depreciated by half, the
interest payment is only $1 million.

Cons of devaluation
The price of goods and services can rise over time as a result of devaluation. Import prices have
risen, prompting customers to buy their goods from domestic producers. The magnitude of the
price increases, on the other hand, is determined by supply and aggregate demand competition.
Increased exports as a result of the currency depreciation will enhance aggregate demand, which
will raise GDP and inflation. Inflation is taken into account since suppliers are faced with increased
import prices, causing manufacturers to raise their cost price and, as a result, their market price.
Furthermore, depreciation might raise market uncertainty. Due to a lack of consumer confidence,
market uncertainty can have a detrimental impact on supply and demand, perhaps leading to a
recession. Furthermore, devaluation may result in a trade war.
Types of devaluation:
External devaluation

Internal devaluation
Competitive devaluation

Fiscal devaluation

Examples of Devaluation
In the past, China’s been cited for practicing devaluation to increase its GDP and become a
dominating force within the global trading scene. In 2016, they were said to be devaluing their
currency to revalue it after the 2016 U.S. presidential election. However, President Donald Trump
imposed tariffs on Chinese goods in response to their plan to increase the value of their currency
relative to the value of U.S. currency.

The Brazilian real was steeply devalued in the past, plunging in value since 2011. As a result, it
encountered many other problems, such as declining crude oil and commodity prices, as well as
corruption.

Another example would be in March 2016, when Egypt’s central bank reduced the Egyptian
pound’s value by 14% relative to the U.S. dollar to decrease any sort of potential black-market
activity. However, the black market in Egypt responded by depreciating the exchange rate
conversion between the U.S. dollar and the Egyptian pound.

Consumption
Consumption means the direct and final use of goods and services in the satisfaction of human
wants. Neoclassical (mainstream) economists generally consider consumption to be the final
purpose of economic activity, and thus the level of consumption per person is viewed as a central
measure of an economy’s productive success. People may consume single- use goods such as
foodstuffs, fuel, etc. and durable-use goods such as tables, clothes, etc. The use of such goods is
called unproductive consumption because their consumption does not help in the production of
other goods. Similarly, the services of doctors, teachers, servants, mechanics, etc. are consumed
for satisfying human wants. The use of such services is called productive consumption because
they help in producing goods and services. Consumption is the dominant component of GNP. A
1% change in consumption is five times the size of a 1% change in investment (Hall, 1986}

Importance of consumption:
• Consumption is not only the beginning but also the end of all human economic activities.
• The consumption pattern of a person gives us knowledge of the standard of living of the
person.
• Consumption is the source of production. Production increases with increase in
consumption.
 • In the formulation of certain economic principles such as the Law of Diminishing Marginal
Utility, the Law of Demand, the Consumer’s Surplus, etc.
• The Government formulates its economic policies on the basis of the consumption habits
of the people.

There are four theories of consumption. They are:

1. Absolute income hypothesis: The Keynesian theoretical consumption function is called
the absolute theory of consumption. Consumption spending is the positive function of the
absolute level of income that is, higher the level of current income, higher is the
consumption demand and vice versa.
2. Relative income hypothesis: This hypothesis was formulated by James Dusenberry which
states that the satisfaction (or utility) an individual derives from a given consumption level
depends on its relative magnitude in the society (e.g., relative to the average consumptio n)
rather than its absolute level.
3. Permanent Income Hypothesis: It is an economic theory about consumption, first
developed by Milton Friedman which states that changed in permanent income, rather than
changes in temporary income, are what drive the changes in a consumer’s consumptio n
patterns.
4. Life-Cycle Hypothesis: Consumption patterns change during different staged of their
lives. Individual want to maintain stable lifestyles to work to build assets during working
lives.

Consumption as part of GDP

Gross domestic product) is defined via this formula:

Y=C+G+I+NX

Where,

C stands for consumption.

G stands for total government spending (including salaries)

I stands for Investments.

NX stands for net exports. Net exports are exports minus imports.
In most countries consumption is the most important part of GDP it ranges usually ranges from
45% from GDP to 85% of GDP.

Government expenditure
Government expenditure refers to the spending on goods and services by the government. Also
some of the expenses where there is no involvement of exchange of goods and services that is
transfer of payments are also included in the government expenditure. Government does expenses
in various sector for promoting and increasing the economic welfare of its people. If the
government spending exceeds the revenue, then the government runs a fiscal deficit and if revenue
exceeds expenditure, the government runs a fiscal surplus. When expenditure equals to revenue, it
is called balanced fiscal.

Government spending involves the following three main categories.

• Transfer payments: Transfer payments do not involve exchanging goods and services,
even if the government hands over the money. It is a one-way payment to a person or
organization which has given or exchanged no goods or services for it which contrasts with
a simple “payment” which in economic refers to a transfer of money in exchange for a
product or service.
• Current expenditures: It covers routine expenditure for operations
• Capital expenditures: It includes spending on infrastructure, such as roads. These
expenditures are vital to increasing the capital stock in the economy
Sources of Government expenditure

Government expenditure is financed primarily through two sources:

1. Tax collections by the government
• Direct taxes
• Indirect taxes
2. Government borrowing
• Borrowing money from its own citizens
• Borrowing money from foreigners

Purposes of Government expenditure

• To supply goods and services that are not supplied by the private sector, such as defense,
roads, and bridges; merit goods such as hospitals and schools, and welfare payments and
benefits including unemployment and disability benefits.
• To achieve improvements in the supply-side of the macro-economy, such as spending on
education and training to improve labor productivity.
• To provide subsidies to industries that may need financial support for either their operation
or expansion. The private sector is not able to meet such financial requirements and, hence,
the public sector plays a crucial part in lending necessary support. For example, transport
infrastructure projects do not attract private finance unless the government provides
expenditures for the industry.
• To help redistribute income and promote social welfare.
Nepal government has allotted 14 kharab,39 Arab, 59 crore as total budget for the year 2078/79
with Kharab, 78 Arab and 61 crore as current expenditure, 3 kharab 74 Arab and 26 crore as capital
expenditure and 3 Kharab 86 Arab and 71 crore as financial distribution to province and local level
(Ministry of Finance, 2078). According to the new budget speech presented by new finance
minister, current expenditure, capital expenditure and financial distribution to province and local
level was reorganized as current expenditure- 6 Kharba,77 Arab and 99 Crore, capital expenditure
as 3 Kharba,78 Arab and 10 Crore and financial distribution to provincial and local level as 3
Kharab, 87 Arab and 30 crore (Ministry of Finance, 2078). Spending contributes to increasing
potential GDP and investment in infrastructure creates a multiplier effect on the economy. Such
investment also increases the productive capacity of the economy in the long run. The period of
recession is prevented by increasing the spending which creates higher aggregate demand
ultimately increasing production and reducing the unemployment rate. Government expenditure is
one of the important contributor of GDP since GDP = C + I + G + NX

Import
Import means purchasing of the product and services produced abroad. If a country imports more
than it export it runs a trade deficit. If it imports less than it exports, trade surplus occurs Due to
the global COVID-19 pandemic, world import was contracted by 9.1 percent and export was
contracted by 9.5 percent and is assumed that world import will rise by 9.1 percent and export will
rise by 7.9 percent in 2021 (IMF, 2021)
In the fiscal year 2077/78 , total import increased by 28.7 percent and reached 1539 arab and 84
crore and total export increased by 44.4 percentage and reached 141 arab, 12 crore and with trade
deficit of 1398 Arab and 71 crore (NRB, 2021)
India has greater contribution to total import that is 30.1 percent , china contributes 28.9 percent
and remaining country contributes 18.7 percentage in the fiscal year 2077/78 (NRB, 2021)
Nepal import petroleum products, parts and accessories of vehicle, M.S-Blade, other machine r ies
and accessories, medicines and so on from India. Similarly, Nepal import aluminum, foil, iron,
bag, camera, chemical matter, chemical fertilizer and so on from India. In addition to these, Nepal
import gold, telecommunication machines, other machines and their accessories, electricity related
items polythene granules and so on from other foreign country
Objectives of Import Trade
• To speed up industrialization
• To meet domestic demand
• To overcome natural disasters
• To improve standard of living
• To ensure national defence
Important Steps Involved in a Typical Import Transaction
• Trade enquiry and sending quotations
• Procurement of import license
• Obtaining foreign exchange
• Placing order or indent
• Obtaining letter of credit
• Arrangement of finance
• Receipt of shipment advice
• Arrival of goods
• Customs clearance and release of goods
Export
An export in international trade is a good produced in one country that is sold into another country
or a service provided in one country for a national or resident of another country. The seller of
such goods or the service provider is an exporter; the foreign buyer is an importer. Services that
figure in international trade include financial, accounting and other professional services, tourism,
education as well as intellectual property rights.
Exporting avoids the cost of establishing manufacturing operations in the target country. Exporting
may help a company achieve experience curve effects and location economies in their home
country. Ownership advantages include the firm's assets, international experience, and the ability
to develop either low-cost or differentiated products. The locational advantages of a particular
market are a combination of costs, market potential and investment risk. Internationaliza tio n
advantages are the benefits of retaining a core competence within the company and threading it
though the value chain rather than to license, outsource, or sell it.
Exporting may not be viable unless appropriate locations can be found abroad. High transport costs
can make exporting uneconomical, particularly for bulk products. Another drawback is that trade
barriers can make exporting uneconomical and risky. Exports could also devalue a local currency
to lower export prices. It could also lead to imposition of tariffs on imported goods.
In macroeconomics, net exports (exports minus imports) are a component of gross domestic
product, along with domestic consumption, physical investment, and government spending.
Foreign demand for a country's exports depends positively on income in foreign countries and
negatively on the strength of the producing country's currency (i.e., on how expensive it is for
foreign customers to buy the producing country's currency in the foreign exchange market).
Benefits of export for the domestic economy
• Stabilize the value of their currency
• Lower the value of their currency
• Maintain liquidity
• Control inflation
• Pay debts

Investment
An investment is an asset or item acquired with the goal of generating income or appreciation.
Appreciation refers to an increase in the value of an asset over time. When an individ ua l
purchases a good as an investment, the intent is not to consume the good but rather to use it in
the future to create wealth.
An investment always concerns the outlay of some resource today—time, effort, money, or an
asset—in hopes of a greater payoff in the future than what was originally put in. For example,
an investor may purchase a monetary asset now with the idea that the asset will provide income
in the future or will later be sold at a higher price for a profit.
 Types of Investments:
• Stocks/Equities:
A share of stock is a piece of ownership of a public or private company. By owning
stock, the investor may be entitled to dividend distributions generated from the net
profit of the company
• Bonds/Fixed-Income Securities:
A bond is an investment that often demands an upfront investment, then pays a
reoccurring amount over the life of the bond. Then, when the bond matures, the investor
receives the capital invested into the bond back.
• Index Funds and Mutual Funds
Instead of selecting each individual company to invest in, index funds, mutual funds,
and other types of funds often aggregate specific investments to craft one investme nt
vehicle.
• Real Estate
Real estate investments are often broadly defined as investments in physical, tangible
spaces that can be utilized. Land can be built on, office buildings can be occupied,
warehouses can store inventory, and residential properties can house families.
• Commodities
Commodities are often raw materials such as agriculture, energy, or metals. Investors
can choose to invest in actual tangible commodities (i.e. owning a bar of gold) or can
choose alternative investment products that represent digital ownership (i.e. a gold
ETF).
• Cryptocurrency
Cryptocurrency is a blockchain-based currency used to transact or hold digital value.
Cryptocurrency companies can issue coins or tokens that may appreciate in value.
These tokens can be used to transact with or pay fees to transact using specific
networks.
• Collectibles
A less traditional form of investing, collecting or purchasing collectibles involves
acquiring rare items in anticipation of those items becoming in higher demand. Ranging
from sports memorabilia to comic books, these physical items often require substantia l
physical preservation especially considering that older items usually carry higher value.
How to Start Investing:
• Do your own research
• Establish a personal spending plan.
• Understand liquidity restrictions
• Research tax implications
• Gauge your risk preference
• Consult an adviser
 AEC-05M-2022
Sushil Shrestha
1. International Trade
International trade is the exchange of capital, goods, and services across international borders or
territories because there is a need or want of goods or services. In most countries, such trade
represents a significant share of gross domestic product (GDP). International trade is the economic
transactions that are made between countries. Among the items commonly traded are consumer
goods, such as television sets and clothing; capital goods, such as machinery; and raw materials
and food. Other transactions involve services, such as travel services and payments for foreign
patents. International trade transactions are facilitated by international financial payments, in
which the private banking system and the central banks of the trading nations play important roles.
International trade and the accompanying financial transactions are generally conducted for the
purpose of providing a nation with commodities it lacks in exchange for those that it produces in
abundance; such transactions, functioning with other economic policies, tend to improve a nation’s
standard of living. Much of the modern history of international relations concerns efforts to
promote freer trade between nations. Carrying out trade at an international level is a complex
process when compared to domestic trade. When trade takes place between two or more states
factors like currency, government policies, economy, judicial system, laws, and markets influe nce
trade.

To ease and justify the process of trade between countries of different economic standing in the
modern era, some international economic organizations were formed, such as the World Trade
Organization. These organizations work towards the facilitation and growth of international trade.
Statistical services of intergovernmental and supranational organizations and governme nta l
statistical agencies publish official statistics on international trade.
The theory of international trade:
Comparative-advantage analysis
David Ricardo developed them into the principle of comparative advantage, The major purpose
of the theory of comparative advantage is to illustrate the gains from international trade. Each
country benefits by specializing in those occupations in which it is relatively efficie nt; each should
export part of that production and take, in exchange, those goods in whose production it is, for
whatever reason, at a comparative disadvantage. The theory of comparative advantage thus
provides a strong argument for free trade—and indeed for more of a laissez- faire attitude with
respect to trade. Based on this uncomplicated example, the supporting argument is simple :
specialization and free exchange among nations yield higher real income for the participants.
cost of production (labor time)
country A country B

wine (1 unit) 1 hour 2 hours

cloth (1 unit) 2 hours 6 hours

Country A is said to have an absolute advantage in the production of both wine and cloth because
it is more efficient in the production of both goods. Accordingly, A’s absolute advantage
seemingly invites the conclusion that country B could not possibly compete with country A, and
indeed that if trade were to be opened up between them, country B would be competitive ly
overwhelmed. The critical factor is that country B’s disadvantage is less pronounced in wine
production, in which its workers require only twice as much time for a single unit as do the workers
in A, than it is in cloth production, in which the required time is three times as great.
This means, Ricardo pointed out, that country B will have a comparative advantage in wine
production. Both countries will profit, in terms of the real income they enjoy, if country B
specializes in wine production, exporting part of its output to country A, and if country A
specializes in cloth production, exporting part of its output to country B.

2. Net export
Net exports are a measure of a country's total trade of goods and services. It is also known as the
balance of trade. It is after deducting the nation's import value from the export value and calculated
for a specific period. It can be either positive or negative. The net export variable is used to
compute the GDP of a country.
Positive vs negative net export
A positive net export figure shows a country’s trade surplus. It means that the value of the nation’s
imports is lower than the value of its exports. A country with a trade surplus receives more money
from a foreign market than it spends.
A negative net export figure is a trade deficit for a given country. It means that the overall value
of the country’s imports is greater than the overall value of its exports. A country with a trade
deficit spends more money in a foreign market than it makes.
Net Exporter vs. Net Importer
Countries produce goods based on the resources and skilled labor capacity available. Whenever a
country cannot produce a particular good efficiently but still wants it, that country can buy it from
other countries who produce and sell that good via an import. Likewise, if other countries demand
goods that your country is able to produce well, they may be available as an export to overseas
markets.
A net exporter is a country, which in aggregate, sells more goods to foreign countries through trade
than it brings in from abroad. Saudi Arabia and Canada are examples of net exporting countries
because they have an abundance of oil which they then sell to other countries that are unable to
meet the demand for energy. A net exporter, by definition, runs a current account surplus in
aggregate.
A net importer, by contrast, is a country or territory whose value of imported goods and services
is higher than its exported goods and services over a given period of time. A net importer, by
definition, runs a current account deficit on whole. The United States tends to be a good example
of a net importer, purchasing consumer products and raw material abroad from countries like China
and India.
Note that a country may run either deficits or surpluses with individual countries or territories
depending on the types of goods and services traded, the competitiveness of these goods and
services, exchange rates, levels of government spending, trade barriers, etc. A net importer or net
exporter looks at the overall balance of trade on net. It is also important to note that a country can
be a net exporter in a certain area, while being a net importer in other areas. For example, Japan is
a net exporter of electronic devices, but it must import oil from other countries to meet its needs.

Calculation of net export

The net export of a country can be computed as follows:
Net export = Value of export-Value of import
Here,
Value of exports is the amount of money generated by a given country for goods and services from
a foreign market.
Value of Imports is the amount of money that the nation has spent on services and goods from
other countries.
Importance of Net Export
1. The net export variable is very important in the computation of a country’s GDP. A trade
surplus is added to the country’s GDP.
2. Net exports can also serve as a measure of financial health for a country. A country with a
high export value generates income from other countries. It reinforces the financial standing of
that country, as the inflow of money gives it the opportunity to trade with other countries.

3. Aggregate demand
Aggregate demand is the total desired quantity of goods and services that are bought by
consumer households, private investors, government and foreigners at each possible price
level, other things held constant. It is not any quantity demanded at a particular price level
but is a schedule of total output demanded at various price level and is represented by a
demand curve. Thus, aggregate demand has four components which are
Consumption demand
Private investment demand
Government purchases of goods and services and
Net exports.

AD = C +I + G + (X – M)
Where, AD = aggregate demand, C = consumer spending, I = investment, G = Governme nt
spending
(X –M) = net export
Thus, an aggregate demand curve depicts the total output of goods and services which
households, firms, and government are willing to buy at each possible price level. Thus,
aggregate demand curve shows the relationship between the total quantity demanded of
goods and services and general price level

Why Does the Aggregate Demand Curve Slope Downward?

The Wealth Effect: Household consumption is most strongly determined by income, but it is
also affected by wealth. Some household wealth is held in nominal assets, so as price levels
rise, the real value of household wealth declines. This results in less consumption.
The Interest Rate Effect: When prices rise, households and firms need more money to
finance buying and selling. This increase in demand for money causes the “price” of holding
money (the interest rate) to rise, discouraging firm investment.
Foreign trade effect: Change in price level also cause a change in foreign demand for goods.
This is called foreign trade effect of the change in price level. Of a general price level in
Nepal falls, its exports will become cheaper leading to their increase. On the other hand, the
lower price level in Nepal will induce Nepalese people to buy Nepalese goods instead of
imported ones. Thus, fall in general price level in Nepal will lead to more exports and lesser
imports causing expansion in aggregate demand for Nepalese good.

4. Aggregate supply
Aggregate supply is the total output of goods and services that firms want to produce at each
possible price level. Thus, like aggregate demand, aggregate supply is the whole schedule of
total quantities of aggregate output that firms in the economy are willing to produce and can
be represented by an aggregate supply curve. It is the outcome of the decisions of all
producers in the economy to hire workers and buy other inputs for production of goods and
services for selling them to consumers, other producers, and government as well as for
exporting them to foreign countries.
Aggregate supply, also known as total output, is the total supply of goods and services produced
within an economy at a given overall price in a given period. It is represented by the aggregate
supply curve, which describes the relationship between price levels and the quantity of output that
firms are willing to provide. Typically, there is a positive relationship between aggregate supply
and the price level.
Rising prices are typically an indicator that businesses should expand production to meet a higher
level of aggregate demand. When demand increases amid constant supply, consumers compete for
the goods available and, therefore, pay higher prices. This dynamic induces firms to increase
output to sell more goods. The resulting supply increase causes prices to normalize and output to
remain elevated.
Changes in Aggregate Supply
A shift in aggregate supply can be attributed to many variables, including changes in the size and
quality of labor, technological innovations, an increase in wages, an increase in production costs,
changes in producer taxes, and subsidies and changes in inflation. Some of these factors lead to
positive changes in aggregate supply while others cause aggregate supply to decline. For example,
increased labor efficiency, perhaps through outsourcing or automation, raises supply output by
decreasing the labor cost per unit of supply. By contrast, wage increases place downward pressure
on aggregate supply by increasing production costs.
Aggregate Supply Over the Short and Long Run
In the short run, aggregate supply responds to higher demand (and prices) by increasing the use of
current inputs in the production process. In the short run, the level of capital is fixed, and a
company cannot, for example, erect a new factory or introduce a new technology to increase
production efficiency. Instead, the company ramps up supply by getting more out of its existing
factors of production, such as assigning workers more hours or increasing the use of existing
technology.
In the long run, however, aggregate supply is not affected by the price level and is driven only by
improvements in productivity and efficiency. Such improvements include increases in the level
of skill and education among workers, technological advancements, and increases in capital.
Certain economic viewpoints, such as the Keynesian theory, assert that long-run aggregate supply
is still price elastic up to a certain point. Once this point is reached, supply becomes insensitive to
changes in price.

Short run aggregate supply curve shows how firms adjust the quantity of real output they will
supply when the price levels, holding all input prices fixed.
Long run aggregate supply curve shows the amount of goods and services an economy can
produce when both labor and capital are fully employed.

5. Circular flow of national income

The circular flow of income or circular flow is a model of the economy in which the major
exchanges are represented as flows of money, goods and services, etc. between economic agents.
The flows of money and goods exchanged in a closed circuit correspond in value but run in the
opposite direction. The circular flow analysis is the basis of national accounts and hence of
macroeconomics. A circular flow of income model is a simplified representation of an economy.
The circular flow of income is a concept for better understanding of the economy as a whole and
for example the National Income and Product Accounts (NIPAs). In its most basic form, it
considers a simple economy consisting solely of businesses and individuals and can be represented
in a so-called "circular flow diagram." In this simple economy, individuals provide the labor that
enables businesses to produce goods and services. These activities are represented by the green
lines in the diagram.

Fig: Model of the circular flow of income and expenditure

Alternatively, one can think of these transactions in terms of the monetary flows that occur.
Businesses provide individuals with income (in the form of compensation) in exchange for their
labor. That income is spent on the goods and services businesses produce. These activities are
represented by the blue lines in the diagram above.

The circular flow diagram illustrates the interdependence of the “flows,” or activities, that occur
in the economy, such as the production of goods and services (or the “output” of the economy) and
the income generated from that production. The circular flow also illustrates the equality between
the income earned from production and the value of goods and services produced.

Of course, the total economy is much more complicated than the illustration above. An economy
involves interactions between not only individuals and businesses, but also Federal, state, and local
governments and residents of the rest of the world. Also not shown in this simple illustration of
the economy are other aspects of economic activity such as investment in capital (produced—or
fixed—assets such as structures, equipment, research and development, and software), flows of
financial capital (such as stocks, bonds, and bank deposits), and the contributions of these flows to
the accumulation of fixed assets.
Types of models:
 a. Two-sector model
In the basic two-sector circular flow of income model, the economy consists of two sectors: (1)
households and (2) firms.

b. Three-sector model

Fig: Three-sector circular flow diagram

The three-sector model adds the government sector to the two-sector model. Thus, the three-sector
model includes (1) households, (2) firms, and (3) government.

c. Four-sector model
The four-sector model adds the foreign sector to the three-sector model. (The foreign sector is also
known as the "external sector," the "overseas sector," or the "rest of the world.") Thus, the four-
sector model includes (1) households, (2) firms, (3) government, and (4) the rest of the world. It
excludes the financial sector.
d. Five-sector model
The five-sector model adds the financial sector to the four-sector model. Thus, the five-sector
model includes (1) households, (2) firms, (3) government, (4) the rest of the world, and (5) the
financial sector. The financial sector includes banks and non-bank intermediaries that engage in
borrowing (savings from households) and lending (investments in firms).

Fig: five sector model diagram

In the five-sector model, there are leakages and injections

Leakage means withdrawal from the flow. When households and firms save part of their incomes
it constitutes leakage. They may be in form of savings, tax payments, and imports. Leakages reduce
the flow of income.
Injection means the introduction of income into the flow. When households and firms borrow
savings, they constitute injections. Injections increase the flow of income. Injections can take the
forms of investment, government spending and exports. As long as leakages are equal to injectio ns,
the circular flow of income continues indefinitely. Financial institutions or capital market play the
role of intermediaries. This means that income individuals receive from businesses and the goods
and services that are sold to them do not count as injections or leakages, as no new money is being
introduced to the flow and no money is being taken out of the flow.
Leakages and injections can occur in the financial sector, government sector and overseas sector.

In the financial sector

In terms of the circular flow of income model, the leakage that financial institutions provide in the
economy is the option for households to save their money. This is a leakage because the saved
money can’t be spent in the economy and thus is an idle asset that means not all output will be
purchased. The injection that the financial sector provides into the economy is investment (I) into
the business/firms sector. An example of a group in the finance sector includes banks or financ ia l
institutions.

In the government sector

The leakage that the Government sector provides is through the collection of revenue through taxes
(T) that is provided by households and firms to the government. This is a leakage because it is a
leakage out of the current income thus reducing the expenditure on current goods and services.
The injection provided by the government sector is government spending (G) that provides
collective services and welfare payments to the community. An example of a tax collected by the
government as a leakage is income tax and an injection into the economy can be when the
government redistributes this income in the form of welfare payments, that is a form of governme nt
spending back into the economy.

In the overseas sector

The main leakage from this sector are imports (M), which represent spending by residents into the
rest of the world. The main injection provided by this sector is the exports of goods and services
which generate income for the exporters from overseas residents. An example of the use of the
overseas sector is Australia exporting wool to China, China pays the exporter of the wool (the
farmer) therefore more money enters the economy thus making it an injection. Another example
is China processing the wool into items such as coats and Australia importing the product by paying
the Chinese exporter; since the money paying for the coat leaves the economy it is a leakage.

Summary of leakages and injections

LEAKAGES INJECTIONS
Saving (S) Investment (I)
Taxes (T) Government Spending (G)
Imports (M) Exports (X)

The state of equilibrium

In terms of the five-sector circular flow of income model the state of equilibrium occurs when the
total leakages are equal to the total injections that occur in the economy. This can be shown as:

Savings + Taxes + Imports = Investment + Government Spending + Exports

OR

S + T + M = I + G + X.
6. CLOSED ECONOMY
A closed economy is one that has no trading activity with outside economies. The closed economy
is therefore completely self-sufficient, which means no imports come into the country and no
exports leave the country. The closed economy neither takes nor provide the foreign loans and
doesn’t receive remittance. If a country is “closed” to trade, as is the case with a closed economy,
it limits the availability of goods and services. The goal of a closed economy is to provide domestic
consumers with everything they need from within the country's borders.

Closed economy is a hypothetical economy. In reality, there are no nations that have economies
that are completely closed. Some oil-producing countries have a history of banning foreign oil
companies from doing business inside their borders.

Mathematically, closed economy can be formulated as:

Y=C+I+G

Where,

Y = National Income.

C = Consumption.

I = Total investment.

G = Government expenditure.

In simple words, the formula can be explained as follows:

The national income of a country is the sum total of the consumption expenditure by its people,
the total investment (by both households and business firms) and the government expenditure.
Since there are no imports or exports in or out of the country, the three stated factors are important
for calculating the country’s total income in a year.

Advantages of closed economies:

• Price fluctuations can be easily fixed.

• There is no competition in the economy for domestic producers, hence they flourish and grow.
• Self-sufficiency is native to the economy, resulting in saving a lot of foreign reserves and
preventing resource outflows.

Disadvantages of closed economies:

• There may be dissatisfaction among consumers as there is no variety in terms of goods and
services available to them.
• Growth for manufacturers will stagnate after a duration of time as consumers are limited in
number.
• There is a limitation of employment opportunities for the people of the country.
• No foreign direct investment restricts the inflow of capital into the country, hence restricting
the potential scale of economic development.
• Fulfilling domestic demand for a country as a whole may prove to be a challenge for the
country.

Why Close Off an Economy?

A completely open economy runs the risk of becoming overly dependent on imports. Also,
domestic producers may suffer as they cannot compete at low international prices. Therefore,
governments may use trade controls like tariffs, subsidies, and quotas to support domestic
enterprises. Circular Flow Diagram in a Closed Economy

Fig: Circular flow diagram in a Closed economy

This diagram represents the circular flow of income in a two-sector economy, which involves
households and business firms.
Since it is a closed economy, the business firms mentioned are domestic firms. There is no flow of
resources from households to international firms as they are restricted in the country. There is an
inflow of income to business firms from households as they consume goods and services produced
or manufactured by these firms in the economy. Outflow consists of the wages, rent, profits etc. to
the household along with the goods and services produced. This cycle repeats itself continuo us ly
in the economy as the demand by the households or the consumers are continuously met with the
supply from the manufacturers. As said, in the case of a closed economy, this cycle induces self-
dependency as the goods or services provided are produced locally in the country.

7. Open economy
An open economy is a type of economy where not only domestic factors but also entities in other
countries engage in trade of products (goods and services). Trade can take the form of manager ia l
exchange, technology transfers, and all kinds of goods and services. Certain exceptions exist that
cannot be exchanged; the railway services of a country, for example, cannot be traded with another
country to avail the service. It contrasts with a closed economy in which internatio na l
trade and finance cannot take place.
An open economy is one that interacts freely with the economies of other countries around the
world. It interacts with the outside world in two ways.
1. It buys and sells goods and services in the world product market.
2. It buys and sells capital assets in the world financial market.
There are a number of economic advantages for citizens of a country with an open economy. A
primary advantage is that the citizen consumers have a much larger variety of goods and services
from which to choose. Additionally, consumers have an opportunity to invest their savings outside
the country. There are also economic disadvantages of an open economy. Open economies are
interdependent on others, and this exposes them to certain unavoidable risks.
Features of open economy
• Market economy is mostly free from trade barriers where exports and imports form a large
percentage of GDP.
• No economy is totally open or closed in terms of restriction and all governments have
varying degrees of control over movements of capital and labor
• Degree of openness of an economy determines a government's freedom to pursue economic
policies of its choice, and the susceptibility of a country to the international economic
cycle.
• In terms of the percentage of GDP dependent on foreign trade, the UK is a more open
economy than the US.
• In an open economy market forces are allowed to determine production level.
• It will buy stock, convertible notes, bonds, and other types of investments from other
nations and sell securities to those nations.
• It does this by taking loans from other countries and lending money to other countries.
• It is possible to send and receive salary and presents from people living in other countries.
• Residents in an open economy are free in their movement or ability to find jobs within the
domestic area of other economies.
• Because of the above factors, the gross domestic and national products differ in an
economy open to trade.

Advantages & Disadvantages

Good financial performance in nations at all stages of development is closely associated with
greater trade and open markets. This has given new chances to workers, customers, and firms
worldwide and aided millions of people in rising out of poverty. Also, an open economy expands
quicker than a closed one.
Additionally, wages and working conditions are often higher in firms that engage in trade than
those that do not. As a result, increased affluence and opportunities for people worldwide
contribute to promoting peace and safety for everyone. In addition, a free economy makes it
possible for more firms to product creation, which is to the enormous benefit of customers.
When an economy is more open, it’s possible that domestic manufacturers would suffer since they
won’t be able to compete with the lower prices offered elsewhere. Economic tremors that begin in
one nation may rapidly ripple across the economies of other nations. A substantial reorganiza tio n
of money on a global scale is possible if either of these governing elements undergoes a shift. A
free economy risks becoming unduly dependent on foreign goods and services.

Open Economy vs Closed Economy

• A closed economy does not engage in international commerce. In contrast, an economy

that participates in international integration through trade, capital movement, and other
resources is open economy macroeconomics.
• A closed system has no socioeconomic ties to the global economy, whereas an open
economy engages in international commerce.
• A closed economy neither borrows nor lends, while an open economy borrows and lends.
• In a closed economy, there is no competition or very little competition. However, the
degree of competition is greater in an open economy.
• A closed economy is not flexible. An open economy is liberal, accessible, and adaptable.
 AEC-06M-2022

Nishan KC

Potential GDP
The Potential GDP is a measure of the economy’s sustainable output where inflationary pressure
is neither increases nor decreases by the intensity of resource usage. Even though one can calculate
the economy’s productive potential in various ways, some approaches only use statistica l
methodologies.
The techniques can vary from trend-based and time-series data analysis to intricate calculatio ns
based on the production function and structural equations. It can also consider a moving average
of actual output. This GDP estimation is frequently useful for macroeconomic modeling, policy
analysis, determining fiscal sustainability, and calculating the structural budget balance.
The Potential GDP definition states that it is the level of GDP that is possible or attainable while
the economy is operating at a maximum resource usage rate over a period. It represents full
employment GDP and gauges the economy’s productive capability, especially at a constant
inflation rate. It plays a significant role in policymaking, but assessment cannot be termed unifor m.
Therefore, potential GDP is not viewable and can only be the positive, non-recessionary long- term
trend of GDP.
Actual GDP levels would vary slightly from potential levels. When there is a recession, it would
be below the potential level, creating an “output gap,” When there is an expansion, it would be
over the potential level, creating an “inflationary gap.” The trend-cycle decomposition models
produce an “attainable” potential GDP growth where it is possible to achieve short-term GDP
growth above the healthy condition.
Capital accumulation and potential GDP
Capital accumulation is a key factor in estimating Potential Gross Domestic Product and a
significant source of production and potential GDP growth. Although capital growth is typically
smooth from a short-term viewpoint, the long-term growth rate might vary significantly for various
reasons. For instance, residential assets have historically experienced rapid expansion and
significantly contributed to total assets before the Great Recession. However, the housing crash
has considerably reduced the real estate sector’s assets and overall capital growth rates. The growth
of the workforce is another significant factor in determining sustainable Potential Gross Domestic
Product growth. The phenomenon where specific unemployment rate when inflation stabilizatio n,
where it will neither rise nor fall. It also serves as one of the factors affecting potential GDP growth.
The degrees of labor market efficiency, production capacity, adequate liquidity, government fiscal
assistance, etc., are additional factors that affect it.

Potential GDP is not the most useful tool for forecasting or guiding policy because it is
unpredictable and varies greatly in value, especially in recent years. Many opine that the value of
Potential Gross Domestic Product is not just dependent on short-term current fiscal and monetary
policy. The idea of potential output, which a growth model can determine, helps assess the
economy’s productive capacity and provides the best basis for estimating Gross Domestic Product
over a decade required by the budgeting process. Potential GDP, when carefully calculated, can
give the economy a fair idea of the economy’s growth potential.

Formula of Potential GDP

Calculation of potential gross domestic product is the labor productivity-growth accounting
method. The formula for estimation is:
The growth rate in potential Gross domestic product= Long term growth rate of labor force+
long term growth rate in labor productivity.
Whereas under the growth accounting equation, the growth rate of output is as follows:
The growth rate (of output) = Rate of technological changes + growth rate of capital + growth
rate of labor.
Potential GDP vs. Real GDP
Real GDP is the value of the output during a period; it may be one quarter or one year. It is
otherwise referred to as actual GDP, whereas; potential GDP refers to the level of output that a
nation’s economy can produce at a constant inflation rate. The ratio between the two, and the level
of economic slowdown, is a major factor influencing fixed-income returns over the short run. The
disparity between actual and potential gross domestic product is the output gap.
When a negative output gap indicates real GDP is below potential GDP, a sluggish economy. It
suggests that there may not be full employment in the economy and the existence of weak demand
for goods and services. To stimulate the economy, central banks like the Fed (U.S.) may explore
cutting interest rates indicating that the economy is not operating at full capacity.
If the output gap is positive real GDP is higher than potential GDP, meaning that aggregate demand
is higher than aggregate supply. Here, the economy is creating more than it can maintain. As a
result, price hikes and inflation may follow in this situation.

Savings
Savings is a stock variable, the result of the flow of saving. Savings rise gradually as saving occurs.
It is measured at a point of time.
Savings by definition means to be “safe” from any potential loss. Savings, therefore, represents
a net surplus of funds for an individual or household after all expenses and obligations have
been paid. Savings are kept in the form of cash or cash equivalents (e.g. as bank deposits), which
are exposed to no risk of loss but also come with correspondingly minimal returns. Savings
accounts are very safe but tend to offer very low rates of return as a result. Negative savings is
indicative of household debt or negative net worth. If one is unable to maintain savings, they may
be said to be living pay check to pay check.
Savings versus Investing
Retirement “saving” is more accurately investing since money put away in these accounts is
used to purchase securities such as stocks, bonds, and mutual funds. When money is invested, it is
at risk of loss- but that risk is offset by positive expected returns over time. Savings, in contrast,
are by definition safe from any risk and potential loss.
Additionally, savings are highly liquid and available for immediate use. Investment on the
other hand, must first be sold into usable cash. This can take some time and may incur
transaction costs. Investment by definition, entail some sort of long-term time horizon to allow the
money to grow and appreciate.
Types of Savings Accounts
• Saving Accounts
A saving accounts pays interest on cash not needed for daily expenses but available for an
emergency. Deposits and withdrawals are made online, by phone, mail, or at a physical bank
branch or ATM. Interest rates of savings accounts tend to be low but are often higher than on
checking accounts. The best savings accounts can usually be found online because they’ll pay a
higher interest rate.
• Checking Accounts
A checking account offers the ability to write checks or use debit cards that draw from your
account. A checking account pays lower interest rates than other bank accounts, and many of them
credit no interest at all to checking customers. In return, however, account holders get highly liquid
and accessible funds often with low or no monthly fees.
• Money market Accounts
It is an interest-bearing account at a bank or credit union. Money Market Accounts often pay higher
interest rates than regular passbook savings accounts and also include check writing and debit card
privileges. These also can come with restrictions that make them less flexible than a regular
checking account.
• Certificates of Deposits (CDs)
A certificate of deposit limits access to cash for a certain period in exchange for a higher interest
rate. Deposit terms range from three months to five years; the longer the term, higher the interest
rate. CDs have early withdrawal penalties that can erase interest earned, so it is best to keep the
money in the CDs for the entire term.

Saving

Saving is a flow variable, a rate of saving per unit time, such as saving per year. A fundame nta l
macroeconomic accounting identity is that saving equals investment. By definition, saving is
income minus spending. Investment refers to physical investment, not financial investment. That
saving equal’s investment follows from the national income equals national product identity.
Saving is process of setting aside a portion of current income for future use, or the flow of resources
accumulated in this way over a given period of time. Saving may take the form of increases in
bank deposits, purchase of securities, or increased cash holdings. The extent to which individ ua ls
save is affected by their preferences for future over present consumption, their expectations of
future income and to some extent by the rate of interest.

Saving is important to the economic progress of a country because of its relation to investment.
If there is to be an increase in productive wealth, some individuals must be willing to abstain from
consuming their entire income. Progress is not dependent on saving alone; there must also be
individuals willing to invest and thereby increase productive capacity.

Consider first an economy without government. Saving is national income minus consumption,
s = ni-c......... (1)
National income equal national product,
ni= np ................(2)

National product is consumption plus investment,

np= c+i ...................(3)
It follows that saving equals investment:
s= ni-c, by (1)
= np-c, by (2)
= (c+i)-c, by (3)
=i,
With government, to show that saving equals investment is harder. Government expenditure refers
to government purchases of goods and services. Taxes include transfer payments and the interest
on government debt as negative taxes. By definition, government saving is taxes minus
government expenditure,
gs= t-g .................(4)

Disposable income is national income minus taxes. Private saving is disposable income minus
consumption,
ps = di-c = (ni-t)-c .............(5)
National income equals national product,
ni=np .................... (6)
National product is consumption plus investment plus government expenditure,
np= c+ i+g ...........................(7)
Total saving is private saving plus government saving:
s = ps+gs
= (ni-t-c)+(t-g), by (4and 5).
= ni-c-g
= np-c-g, by (6)
= (c+i+g)- c-g, by (7)
= i, as desired.

Example
Consider an initial economic state in which a student buys a football for $1. Of course,
saving equals investment. Contrast this situation to an alternative economic state, in which the
student does not buy the football. The sporting goods store still has the football, and the student
has his dollar. Otherwise the alternative state is identical to the initial state. What has happened to
saving and investment?
The saving of the student has increased $1. Investment has also increased by $1. The store has extra
inventory of $1, and inventory accumulation counts as investment.
Trade liberalization
Trade liberalization is the removal or reduction of barriers in the flow of goods and services across
the border of economies/countries encouraging free trade. Trade liberalization involves:
• Reducing tariffs
• Reducing/eliminating quotas
• Reducing non-tariff barriers.
Non-tariff barriers are factors that make trade difficult and expensive. For example, having specific
regulations on making goods can give an unfair advantage to domestic producers.
Advantages of Trade Liberalization
• Comparative advantage. Trade liberalization allows countries to specialize in producing the
goods and services where they have a comparative advantage (produce at lowest opportunity cost).
• Lower prices. The removal of tariff barriers can lead to lower prices for consumers. E.g.
removing food tariffs in West would help reduce the global price of agricultural commodities. This
would be particularly a benefit for countries who are importers of food.
• Increased competition. Trade liberalization means firms will face greater competition from
abroad. This should act as a spur to increase efficiency and cut costs, or it may act as an incentive
for an economy to shift resources into new industries where they can maintain a competitive
advantage.
• More advantages of free trade.
Problems of Trade Liberalization
• Structural unemployment: Trade liberalization often leads to a shift in the balance of an
economy. Some industries grow, some decline. Therefore, there may often be structural
unemployment from certain industries closing. Trade liberalization can often be painful in the short
run, as some industries and some workers suffer from the decline in uncompetitive firms.
• Environmental costs. Trade liberalization could lead to greater exploitation of the environme nt,
e.g. greater production of raw materials, trading toxic waste to countries with lower environme nta l
laws.

Deflationary Gap

A deflationary gap occurs when the actual real GDP is below its potential output. In this situatio n,
some economic resources are underutilized, which in turn, creating a downward pressure on price
level. The deflationary gap refers to conditions where the productive capacity of the economy is
underutilized, while deflation is a condition when the general price level declines (negative
inflation).
How do deflationary gaps occur?

Aggregate demand (Aggregate demand is a measurement of the total amount of demand for all
finished goods and services produced in an economy.) And short-run aggregate supply
(Short-run aggregate supply refers to aggregate output when some costs are variable.) Fluctuate in
the short-run. Such fluctuation causes actual real GDP to deviate from potential GDP (Potential
GDP refers to the maximum output an economy can produce using its existing economic
resources).
Economists call the deviation of real GDP from its potential as the output gap. The output gap can
be positive or negative. The positive output gap occurs when aggregate demand and short-run
aggregate supply intersects (short-run equilibrium) above its potential output. This situation refers
to the inflationary gap (positive output gap). However, when short-run equilibrium is below its
potential output, it is a deflationary gap (negative output gap).
Causes of Deflationary gap
A deflationary gap could occur when aggregate demand declines. For example, the
global recession reduces foreign demand for domestic products. Exports decline, so do
with aggregate demand.
High-interest rate environment also contributes to lower aggregate demand. In this case, new loans
become costlier. Households reduce their spending on durable goods, and companies postpone
their investment spending.
Other factors that reduce aggregate demand are higher taxes, more pessimistic consumers and
businesses, and lower equity and housing prices. A decrease in aggregate demand results in lower
real GDP and lower prices levels. The economy operates below its potential output.
Implications on the economy
When the economy experiences a deflationary gap, economic growth and inflation rate are lower
(or even negative). When a decrease in aggregate demand bring the economy into a recession, real
GDP and the price level fall (deflation).
Companies face excess capacity. Prices and wages put on the downward pressure. Their profit
margins shrink and force them to reduce labor, causing a higher unemployment rate.
Households become more pessimistic on their future job and income prospects. As a result, they
spend less on goods and services.
For the government, a decline in economic activity causes tax revenues to fall.
In financial markets, investors will usually reduce investment in cyclical companies
and commodity-based companies. They began to reallocate investment more on
defensive companies as they have a more stable performance during an economic slowdown.

Inflationary Gap
An inflationary gap is a macroeconomic concept that measures the difference between the current
level of real gross domestic product (GDP) and the GDP that would exist if an economy was
operating at full employment.
KEY TAKEAWAYS
• An inflationary gap measures the difference between the current level of real GDP and the GDP
that would exist if an economy was operating at full employment.
• For the gap to be considered inflationary, the current real GDP must be higher than the potential
GDP.
• Policies that can reduce an inflationary gap include reductions in government spending, tax
increases, bond and securities issues, interest rate increases, and transfer payment reductions.

Inflationary Gap = Real or Actual GDP – Anticipated GDP

Importance of inflationary gap

1. It can be reduced by increasing savings such that aggregate demand is reduced.
2. When the inflationary gap is in play, it is very difficult to increase production because all
resources have been utilized.
3. If government spending, the tax generates, securities issues are curbed, the inflationary gap
might be reduced.
Disadvantage of inflationary gap:
• The excess gap between the current income, current expenditure, and current consumption is
taken whereas corresponding factors already produced in the economy are ignored in the analysis.
• Inflation is not a static process. It keeps on changing with improbable and varying
degrees. However, the study of the inflationary gap is founded on static nature basis.

Target Savers
The target saver refers to a household (or individual) that saves in the present for a very
specific goal, namely, to fund a target level of consumption in the future. In this framework, should
the interest rate on current household saving increase, then the household can actually save less
in the present (and thus spend more in the present) and still achieve its target level of
future consumption (Cebula & Menon, 2008). Target Saver is a simple and flexible way to
invest regularly for longer term goals. It can fit into your broader saving strategy as follows:
Choose your monthly contributions -
Your financial advisor will help determine a monthly premium that best suits you. This can depend
on a number of factors including, how much you can contribute and/or your long term savings
needs and goals. Target Saver (the plan) is designed to protect your savings against the effects of
inflation. Premium amounts will increase by 3% every year. However, you can choose to keep
your monthly premium the same throughout the life of the policy if you want to.
Remember the plan is completely flexible. You can increase or decrease premiums in the future
subject to the minimum and maximum limits. You can also set up your plan so you do not
contribute monthly premiums in the months of December and January. If you choose this option
your monthly premium will automatically be skipped every December and January.
Your choice of investments -
We have a range of funds to suit different needs and preferences. Some are designed to keep
investment risk low, while others aim for higher growth potential, but are subject to more
investment risk. It is important to pick funds that suit you and your goals. Investing in funds carries
risk (at varying degrees). You could lose some or all of the amount invested. If you chose to invest
in a fund that invests in shares or bonds, the assets in that fund may be used for the purpose of
securities lending in order to earn an additional return for the fund. While securities lending
increases the level of risk within a fund, it provides an opportunity to increase the investme nt
return. The classification of investment risk is indicated on our relevant fund flyer.
Your financial advisor will help you find the fund selection that is right for you based on your
goals, your investment objectives, and your attitude to investment risk.
We understand that your needs may change during the term. You can switch funds up to 6 times a
year, without incurring a charge.

The target saver goal can be achieved by following steps:

• Choose your monthly contributions:
The monthly contribution towards the target saver can be achieved by proper implementation of
the program.
• Choice of investment
• Target feature
 Kritim Shrestha
AEC-07M-2022

1. Full employment:
Full employment is often described as the level of employment at which virtually anyone who
wants to work can find employment at the prevailing wage. One might assume that if everyone
who wants a job has one, then the unemployment level would be zero. It is an economic situatio n
in which all available labor resources are being used in the most efficient way possible. Full
employment embodies the highest amount of skilled and unskilled labor that can be employed
within an economy at any given time.
It is the highest level of employment the economy can sustain without generating unwelcome
inflation. It can also be defined as an economy in which the unemployment rate equals the
Nonaccelerating Inflation Rate of Unemployment (NAIRU), no cyclical unemployment exists, and
GDP is at its potential.
It is a theoretical goal for economic policymakers to aim for rather than an actually observed state
of the economy because it is not practically possible to eliminate all unemployment from all

sources.

Fig: full employment

In this diagram, full employment would be at an output of Y2. Here any further increase in AD
only causes inflation. In practice, it is difficult to know precisely what counts as full employme nt.
Practical reasons make it difficult for every firm to operate at 100% capacity. But in order to define
full employment, we would say there is no demand-deficient unemployment, only supply- side
unemployment (such as frictional/structural).
2. Frictional unemployment:
Frictional unemployment occurs with voluntary employment transitions within an economy. As
workers choose to move from one job to another and new workers enter the workforce for the first
time, a temporary period of unemployment is created.
Frictional unemployment can be evident in a growing, stable economy and is regarded as a part of
natural unemployment, the minimum unemployment rate in an economy due to economic forces
and the movement of labor. The frictional unemployment rate is calculated by dividing the workers
actively looking for jobs by the total labor force. The workers actively looking for jobs are typically
classified into three categories: workers who left their job, people returning to the workforce, and
new entrants.

Frictional unemployment differs from other forms of unemployment as it is voluntary and has little
to do with the wider economy. Simply put, it evolves around the decisions of individuals.

For instance, many workers have become fed up with their nine to five job. This may be due to the
nature of the work, or purely the daily grind of traveling. Often, this can lead to a lot of stress and
in turn their resignation. There are many reasons a worker may become discontented. Perhaps it’s
salary or the treatment they receive from other workers or their manager. Whatever it is, it can
cause them to resign without another job lined up. In turn, there is a period between where they
quit and a subsequent new job which can be referred as frictional unemployment.

Frictional unemployment always exists in an economy with a free-moving labor force and is
beneficial because it’s an indicator that individuals are seeking better positions by choice. It also
helps businesses because it gives them a wider selection of potentially highly qualified candidates
applying for positions. It is short-term and thus does not place much of a drain on governme nt
resources. Frictional unemployment is reduced by quickly matching prospective job seekers with
job openings.
3. Structural unemployment:
Structural unemployment is a longer-lasting form of unemployment caused by fundamental shifts
in an economy and exacerbated by extraneous factors such as technology, competition, and
government policy. Structural unemployment occurs because workers lack the requisite job skills
or live too far from regions where jobs are available and cannot move closer. Jobs are available,
but there is a serious mismatch between what companies need and what workers can offer.
Example: Ajay lost his job as a graphic artist at a movie studio because he did not have training in
computer-generated animation.

A variety of factors contribute to structural unemployment. Here are five potential causes:
a. Technological advancement:
New technologies allow businesses to automate systems, increase efficiency and retire
previous business methods. This causes many positions to become obsolete, especially in
the manufacturing, agriculture and trade industries.
b. Lack of internal training and education programs:
When a business provides its employees with minimal opportunities for development, it
can cause structural unemployment. This is because employees don't have the skills they
need to adapt to new technologies or business practices.
c. Company relocation:
Another cause of structural unemployment is when businesses relocate to other states or
countries. Depending on local job opportunities, previous employees may not be able to
find similar jobs requiring their skills or knowledge in the area.
d. Government changes:
Sometimes governmental policies also affect employees' abilities to perform their duties or
can cause companies to relocate to different countries. These changes prevent professiona ls
from adapting to quickly changing environments and can cause them to become
unemployed before they’ve developed other skills.
e. Economic shifts:
Employees who are in trendy industries, such as the foodservice, hospitality and retail
industries, can experience drastic changes with economic shifts. For example, employees
who produce a specialty clothing product that suddenly is no longer a trend might lose their
position producing this specific product, causing structural unemployment.
4. Disguised unemployment:
Disguised unemployment exists when part of the labor force is either left without work or is
working in a redundant manner such that worker productivity is essentially zero. It is
unemployment that does not affect aggregate output. An economy demonstrates disguised
unemployment when productivity is low and too many workers are filling too few jobs.
Disguised unemployment exists frequently in developing countries whose large populations create
a surplus in the labor force. It can be characterized by low productivity and frequently accompanies
informal labor markets and agricultural labor markets, which can absorb substantial quantities of
labor.

Disguised, or hidden, unemployment can refer to any segment of the population not employed at
full capacity, but it is often not counted in official unemployment statistics within the national
economy. This can include those working well below their capabilities, those whose positions
provide little overall value in terms of productivity, or any group that is not currently looking for
work but is able to perform work of value.

Another way to think about disguised unemployment is to say that people are employed but not in
a very efficient way. They have skills that are being left on the table, are working jobs that do not
fit their skills (possibly due to an inefficiency in the market that fails to recognize their skills), or
are working but not as much as they would like.
Underemployment, illness, disability, lack of interest on the designated work etc. are some of the
possible causes of disguised unemployment.

For instance, in rural areas, where agriculture is the main source of income, this kind of
unemployment can be seen often. If a piece of land requires only three people to work on it and
instead five people are working on it, then the two extra people are said to be in a situation of
disguised unemployment.
Thus, disguised unemployment is the situation when people are apparently working but all of them
are made to work less than their potential.

5. Employment
Employment is an agreement between an individual and another entity that stipulates the
responsibilities, payment terms and arrangement, rules of the workplace, and is recognized by the
government.
The employment level is defined as the number people engaged in productive activities in an
economy. There are three types of employment:

a. Self-employment
b. Causal wage labor employment
c. Regular salaried employment
d. Full time employment
e. Part-time employment
f. Contract employment
 • Self-employment: It is a type of employment in which a person or group owns and operate
business enterprise and earns profit. Here person works for oneself not for the employer.
Example: a businessman.

• Causal wage labor employment: It is a type of employment where the workers are
employed for a small period of time. In this type the workers are not hired on a regular
basis and they are paid by the employers on a daily wage basis. Example; person working
on a construction site,

• Regular salaried employment: In this type of employment, the workers work regularly and
earn salaries for their work on the regular basis.
Example: Government office employment, bank employment etc.

• Full time employment: In this type of employment, employees get hired for unspecified
periods, with their contracts only ending when an employer or employee terminate them.

• Part-time employment: In part-time employment employees have open-ended contracts.

They have benefits and responsibilities similar to full-time employees. The employees
work for fewer hours in part time employment compared to full time employment.

• Contract employment: Contract employment is also known as fixed-term employme nt

because it involves a fixed-term contract i.e. employees work for an employer for a set
period. These contracts have clear start and end dates. Contractors may work as full-time,
part-time or casual employees during their contract period but have to complete their jobs
before deadline.

6. Unemployment:
The term unemployment refers to a situation where a person actively searches for employment but
is unable to find work. The most frequently used measure of unemployment is the unemployme nt
rate. It's calculated by dividing the number of unemployed people by the number of people in the
labor force. The unemployment definition doesn't include people who leave the workforce for
reasons such as retirement, higher education, and disability.

Types of Unemployment:
Unemployment—both voluntary and involuntary—can be broken down into four types.

a. Frictional unemployment:
Frictional unemployment occurs with voluntary employment transitions within an
economy. As workers choose to move from one job to another and new workers enter the
workforce for the first time, a temporary period of unemployment is created which is called
frictional unemployment.
 b. Cyclical unemployment:
Cyclical unemployment is the variation in the number of unemployed workers over the
course of economic upturns and downturns. Unemployment rises during recessionary
periods and declines during periods of economic growth is called cyclical unemployment.

c. Structural unemployment:
Structural unemployment is a longer-lasting form of unemployment caused by fundame nta l
shifts in an economy and exacerbated by extraneous factors such as technology,
competition, and government policy. Structural unemployment occurs because workers
lack the requisite job skills or live too far from regions where jobs are available and cannot
move closer. Jobs are available, but there is a serious mismatch between what companies
need and what workers can offer.

d. Disguised unemployment:
Disguised unemployment exists when part of the labor force is either left without work or
is working in a redundant manner such that worker productivity is essentially zero. It is
unemployment that does not affect aggregate output. An economy demonstrates disguised
unemployment when productivity is low and too many workers are filling too few jobs.

7. Money:
Money is a system of value that facilitates the exchange of goods. The use of money eliminates
the problem of bartering where both parties must have something the other wants or needs.
Historically, the first forms of money were agricultural commodities, such as grain or livestock.
Today, most money systems are based on standardized currencies that are controlled by central
banks. Digital cryptocurrencies also have some of the specific properties of money.

Money is a liquid asset used to facilitate transactions of value. It is used as a medium of exchange
between individuals and entities. It's also a store of value and a unit of account that can measure
the value of other goods. Money should be fungible, durable, portable, recognizable, and stable.

There are four different types of money:

• Commercial bank money:

Commercial bank money consists mainly of deposit balances that can be transferred either
by means of paper orders (e.g., checks) or electronically (e.g., debit cards, wire transfers,
and Internet payments).

• Fiduciary money:
Money that is accepted as a medium of exchange due to the trust that exists between the
payer and the payee is known as fiduciary money. Cheques and bank notes are the example
of fiduciary money.
• Fiat money:
A fiat money is a type of currency that is declared legal tender by a government but has no
intrinsic or fixed value and is not backed by any tangible asset, such as gold or silver.
Example: US dollar in Nepal.

• Commodity money:
Money whose value comes from a commodity of which it is made is known as commodity
money. Example: gold coin, silver coin etc.
 Dev Raj Sharma Jaisi
AEC-08M-2022

Cryptocurrency
"Crypto" refers to the various encryption algorithms and cryptographic techniques that safeguard
these entries, such as elliptical curve encryption, public-private key pairs, and hashing functio ns.
Cryptocurrency is a digital or virtual currency that is secured by cryptography, which makes it
nearly impossible to counterfeit or double-spend. A defining feature of cryptocurrencies is that
they are generally not issued by any central authority, rendering them theoretically immune to
government interference or manipulation.
A cryptocurrency is a form of digital asset based on a network that is distributed across a large
number of computers. This decentralized structure allows them to exist outside the control of
governments and central authorities. The word “cryptocurrency” is derived from the encryption
techniques which are used to secure the network. Blockchains, which are organizational methods
for ensuring the integrity of transactional data, are an essential component of many
cryptocurrencies.
Many experts believe that blockchain and related technology will disrupt many industr ies,
including finance and law. Cryptocurrencies face criticism for a number of reasons, including their
use for illegal activities, exchange rate volatility, and vulnerabilities of the infrastruc ture
underlying them. However, they also have been praised for their portability, divisibility, infla tio n
resistance, and transparency.
Advantage
• It makes it easier to transfer funds directly between two parties, without involvement of a
trusted third party like a bank or credit card company.
• Transfer of funds are secured by the use of public keys and private keys.
• Fund transfers are completed with minimal processing fees.
Disadvantage
• The semi-anonymous nature of cryptocurrency transactions makes them well-suited for a
host of illegal activities, such as money laundering and tax evasion.
• Many consumers may lack familiarity with cryptocurrencies and how they work and derive
value.
• Existing laws and regulations do not adequately protect consumers dealing in
cryptocurrencies.

Currency
Currency is a generally accepted form of payment, usually issued by a government and circulated
within its jurisdiction. Simply, it is a medium of exchange for goods and services. In short, it's
money, in the form of paper or coins, usually issued by a government and generally accepted at its
face value as a method of payment. Currency is the primary medium of exchange in the modern
world, having long ago replaced bartering as a means of trading goods and services. Currency in
some form has been in use for at least 3,000 years. Money, usually in the form of coins, proved to
be crucial to facilitating trade across continents. The concept of using paper as a currency may
have been developed in China as early as 1000 BC, but the acceptance of a piece of paper in return
for something of real value took a long time to catch on. Modern currencies are issued on paper in
various denominations, with fractional issues in the form of coins. In the 21st century, a new form
of currency has entered the vocabulary, the virtual currency. Virtual currencies such as bitcoins
have no physical existence or government backing and are traded and stored in electronic form.
The value of any currency fluctuates constantly in relation to other currencies. The currency
exchange market exists as a means of profiting from those fluctuations
Cause & Effect of Currency in the economy
Currency fluctuations are a natural outcome of floating exchange rates, which is the norm for most
major economies
• Currency exchange rates can impact merchandise trade, economic growth, capital flows,
inflation and interest rates.
• Examples of large currency moves impacting financial markets include the Asian Financia l
Crisis and the unwinding of the Japanese yen carry trade.
• Investors can benefit from a weak greenback by investing in overseas equities. A weaker
dollar can boost their returns in U.S. dollar terms.
• Investors should hedge their foreign currency risk via instruments such as futures, forwards
and options.
Merchandise Trade:
This refers to a nation's imports and exports. In general, a weaker currency makes imports more
expensive, while stimulating exports by making them cheaper for overseas customers to buy. A
weak or strong currency can contribute to a nation's trade deficit or trade surplus over time. A
stronger currency can reduce export competitiveness and make imports cheaper, which can cause
the trade deficit to widen further, eventually weakening the currency in a self-adjusting
mechanism. But before this happens, export dependent industries can be damaged by an unduly
strong currency.
Economic Growth:
Gross domestic product (GDP) is the monetary value of all finished goods and services made
within a country during a specific period. GDP provides an economic snapshot of a country, used
to estimate the size of an economy and growth rate. GDP can be calculated in three ways, using
expenditures, production, or incomes. It can be adjusted for inflation and population to provide
deeper insights. GDP is a key tool to guide policy-makers, investors, and businesses in strategic
decision-making. The higher the value of net exports, the higher a nation's GDP.Net exports have
an inverse correlation with the strength of the domestic currency.
GDP=C+I+G+(X−M)
where:
C = Consumption or consumer spending, the biggest component of an economy
I = Capital investment by businesses and households
G=Government spending
(X−M) = Exports−Imports, or net exports
Capital Flows:
Foreign capital tends to flow into countries that have strong governments, dynamic economies,
and stable currencies. A nation needs a relatively stable currency to attract capital from foreign
investors. Otherwise, the prospect of exchange-rate losses inflicted by currency depreciation may
deter overseas investors.
Inflation:
A devalued currency can result in "imported" inflation for countries that are substantial importers.
A sudden 20% decline in the domestic currency could result in imports costing 25% more, as a
20% decline means a 25% increase is needed to get back to the original price point.
Interest Rates:
As mentioned earlier, exchange rates are a key consideration for most central banks when setting
monetary policy
A strong domestic currency exerts drag on the economy, achieving the same result as a tighter
monetary policy (i.e. higher interest rates). In addition, further tightening of monetary policy at a
time when the domestic currency is already strong may exacerbate the problem by attracting hot
money from foreign investors seeking higher yielding investments (which would further
strengthen the domestic currency).

Bitcoin
Bitcoin is an online communication protocol that facilitates the use of a virtual currency, includ ing
electronic payments. Since its inception in 2009 by an anonymous group of developers (Nakamoto
2008), Bitcoin has served approximately 62.5 million transactions between 109 million accounts.
Bitcoin is built on a transaction log that is distributed across a network of participating computers.
It includes mechanisms to reward honest participation, to bootstrap acceptance by early adopters,
and to guard against concentrations of power. Bitcoin’s design allows for irreversible transactions,
a prescribed path of money creation over time, and a public transaction history. Anyone can create
a Bitcoin account, without charge and without any centralized vetting procedure— or even a
requirement to provide a real name. Collectively, these rules yield a system that is understood to
be more flexible, more private, and less amenable to regulatory oversight than other forms of
payment—though as we discuss in subsequent sections, all these benefits face important limits.
Bitcoin is of interest to economists as a virtual currency with potential to disrupt existing payment
systems and perhaps even monetary systems (Bohme et al., 2015). Even at their current early stage,
such virtual currencies provide a variety of insights about market design and the behavior of buyers
and sellers. This article presents the platform’s design principles and properties for a nontechnica l
audience; reviews its past, present, and future uses; and points out risks and regulatory issues as
Bitcoin interacts with the conventional financial system and the real economy. Bitcoin can be
understood as the first widely adopted mechanism to provide absolute scarcity of a money supply.
By design, Bitcoin lacks a centralized authority to distribute coins or to track who holds which
coins. Consequently, the process of issuing currency and verifying transactions is considerably
more difficult than in classic bookkeeping systems. Meanwhile, Bitcoin issues new currency to
private parties at a controlled pace in order to provide an incentive for those parties to maintain its
bookkeeping system, including verifying the validity of transactions.
Compared with conventional payment systems, Bitcoin lacks a governance structure other than its
underlying software. This has several implications for the functioning of the system. First, Bitcoin
imposes no obligation for a financial institution, payment processor, or other intermediary to verify
a user’s identity or cross-check with watch-lists or embargoed countries. Second, Bitcoin imposes
no prohibition on sales of particular items; in contrast, for example, credit card networks typically
disallow all manner of transactions unlawful in the place of sale (MacCarthy 2010). Finally,
Bitcoin payments are irreversible in that the protocol provides no way for a payer to reverse an
accidental or unwanted purchase, whereas other payment platforms, such as credit cards, do
include such procedures.
Money supply
Money supply refers to the total amount of money with public i.e. total amount of money
circulating in an economy at a particular point in time. This circulating money includes liquid
money (paper note and coins), money deposits in an account and other forms of liquid assets.
The record of total money supply is kept by the country pioneer bank. In terms of Nepal, Nepal
Rastra Bank is a leading country in printing of Nepalese currencies and controlling the money
supply of the country. The change in money supply can affect the prices of the securities, inflatio n,
rates of exchange, business cycles etc. The central bank monitors the money supply in an economy
through the different monetary policies which can be expansionary or contractionary, based on the
country's economic situation.
The supply of money should be optimum, it should not be neither high nor low. The increase in
country money supply can lead inflation as a negative effect and economy growths as a
positive effect.
Positive and Negative effect of Money Supply

M1 Money supply
M1 is a narrow measure of money supply which includes liquid currency, demand deposits, and
other liquid deposits. This includes such types of currency or assets that can be quickly converted
to cash. M1 doesn’t include bonds and shares that can't be converted into cash in a given period of
time. M1 is the country’s basic money supply that can be used as an exchange. It can be used to
determine the total amount of money circulated in an economy which is only 100% liquid deposits
which is very narrow in the money supply.

M1= C + DD + OD (Narrow Money)

Whereas C denotes currency held by the public
DD- Demand Deposits with banks
OD- Other deposits (Demand Deposits held by Nepal Rastriya Bank)
 Currency refers to the liquid money (paper note and coins) that can be immediately used in the
exchanging process.
Demand Deposits refers to that amount of money supply that can be withdrawn instantly for
immediate use through exchange mediums like debit cards and ATMs.

M2 Money supply
M2 includes all amounts of M1 (liquid Currency + Demand Deposits + Other Demand Deposits
in NRB) plus near money (Saving deposits). These assets are less liquid than M1 but can convert
quickly into cash and cheque deposits. It is the most commonly accepted measure because it
includes M1 in addition with marketable securities and less liquid deposits.
It is the broader money classification than M1 because this includes assets that are highly liquid
but are not cash. Generally, consumers never use the savings deposits money while purchasing or
paying bills but it could convert them into cash in a short period of time. M1 and M2 are closely
related in that the business man can transfer a certain amount of money from the money market
account to the checking account. This will increase the M1, which doesn’t include money market
funds, while keeping M2 stable as the M2 consists of money market funds.
M2 as a measurement of the money supply is a critical factor in the forecasting of issues like
inflation. Inflation and interest rates have major ramifications for the general economy as these
heavily influence employment, consumer spending, business investment, currency strength and
trade balances.
M2 provides important insight into the direction, efficiency and extremity of the central bank.
M2 = M1 + Saving deposits
M1= C + DD + OD (Narrow Money)
Whereas C denotes currency held by the public
DD- Demand Deposits with banks
OD- Other deposits (Demand Deposits held by Nepal Rastriya Bank)
Nepal Money supply M2 was reported at 42.711 USD bn in Sep 2022. This records an increase from
the previous number of 42.363 USD bn for Aug 2022. Nepal money supply M2 data is updated
monthly.

M3 Money Supply
It is the measure of the money supply that includes M2 as well as large time deposits, institutio na l
money markets funds, short term repurchase agreements and larger liquid assets. The M3 money
supply means the broadest measure of an economy that is time bound to use and less liquid
component of money supply. It emphasizes money as a store-of-value rather than as a medium of
exchange. Less-liquid assets include those that are not easily convertible to cash and therefore not
ready to use when needed.
M3 was formerly used by economists to estimate the entire money supply within an economy and
by central banks to direct monetary policy in order to control inflation, consumption, growth and
liquidity, over medium and long-term periods.
M3 = M1 + Time Deposits
M1= C + DD + OD (Narrow Money)
Whereas C denotes currency held by the public
DD- Demand Deposits with banks
OD- Other deposits (Demand Deposits held by Nepal Rastriya Bank)
In order to calculate M3, each component is given equal weight. For example, M2 and large time
deposits are treated the same and aggregated without any adjustments, which does create a
simplified calculation which is not an actual economy.

M4 Money Supply
As the total deposits with the post office are negligible there is not much difference between M3
and M4. It is the most illiquid measure of money.
M4 = M3 + least liquid assets (Time deposits with Post Office excluding National Saving
certificates)
M3 = M1 + Time Deposits
M1= C + DD + OD (Narrow Money)
Whereas C denotes currency held by the public
DD- Demand Deposits with banks
OD- Other deposits (Demand Deposits held by Nepal Rastriya Bank)

Measure of Money Supply

Measure of money supply Commercial Bank Post office

Currency + Coins DD TD DD TD
M1 ✔ ✔
M2 ✔ ✔ ✔
M3 ✔ ✔ ✔
M4 ✔ ✔ ✔ ✔ ✔
 Keshav Raj Kapadi
AEC-09-2022

Transaction Demand

The amount of money needed to cover the needs of an individual, firm, or nation. That is,
transaction demand for money is a measure of how much of a certain currency people need
in order to buy the goods and services they use. According to Keynes, transaction demand
for money is mainly determined by the level of income. It is positively associated with the
level of Income. Higher the level of income, the larger would be the size of money-hold ings
for transactions.

For example, the size of transaction demand for money at income level of Rs 1,000 crores
will be larger than that at the income level of 700 crores. Mind, it is not the size of nationa l
income but proportion of it which people hold as cash balance that determines the transaction
demand for money it is perfectly interest inelastic.

Precautionary Demand
Precautionary demand for money is motives for holding money to provide a buffer against
unexpected events that might require cash. In a precautionary motive, you worry about what might
happen. You may need money to anticipate if you are sick or lost your job. You never know what
will happen. And the higher the uncertainty, the more likely you are to save money. But now, the
motive for precaution may be less important, namely, because it is easier to turn assets into cash.
Also, people have credit cards now, so you don’t need to put some money into the mattress; if you
have an emergency, you can use a credit card.The precautionary motive is one of the three reasons
for asking for money. The other two motives are for transactions and speculation.

1. The transaction motive is money held to facilitate daily payments.

2. Speculation motive. It is related to the function of money as a store of value. Because there are
many alternative assets, in general, money demand is positively correlated with asset prices and
negatively associated with the risk of those assets. For example, people expect stock prices to fall,
then most rational people will sell shares and save money.

In general, the demand for money as a precaution positively correlated with average transaction
size, total transaction volume, and, therefore, also to overall gross domestic product (GDP). Price
expectations also affect its value. When people expect the price of goods to increase in the future,
they will reduce the demand for money just in case and spend money on products now before the
actual price increase.

Liquidity
For example, if a person wants a $1,000 refrigerator, cash is the asset that can most easily be used
to obtain it. If that person has no cash but a rare book collection that has been appraised at $1,000,
they are unlikely to find someone willing to trade them the refrigerator for their collection. Instead,
they will have to sell the collection and use the cash to purchase the refrigerator. That may be fine
if the person can wait for months or years to make the purchase, but it could present a problem if
the person only had a few days. They may have to sell the books at a discount, instead of waiting
for a buyer who was willing to pay the full value. Rare books are an example of an illiquid asset.
There are two main measures of liquidity: market liquidity and accounting liquidity.
Market Liquidity
Market liquidity refers to the extent to which a market, such as a country's stock market or a city's
real estate market, allows assets to be bought and sold at stable, transparent prices. In the example
above, the market for refrigerators in exchange for rare books is so illiquid that, for all intents and
purposes, it does not exist. The stock market, on the other hand, is characterized by higher market
liquidity. If an exchange has a high volume of trade that is not dominated by selling, the price a
buyer offers per share (the bid price) and the price the seller is willing to accept (the ask price) will
be fairly close to each other. Investors, then, will not have to give up unrealized gains for a quick
sale. When the spread between the bid and ask prices tightens, the market is more liquid, when it
grows the market instead becomes more illiquid. Markets for real estate are usually far less liquid
than stock markets. The liquidity of markets for other assets, such as derivatives, contracts,
currencies, or commodities, often depends on their size, and how many open exchanges exist for
them to be traded on.
Accounting Liquidity
Accounting liquidity measures the ease with which an individual or company can meet their
financial obligations with the liquid assets available to them—the ability to pay off debts as they
come due.In the example above, the rare book collector's assets are relatively illiquid and would
probably not be worth their full value of $1,000 in a pinch. In investment terms, assessing
accounting liquidity means comparing liquid assets to current liabilities, or financial obligatio ns
that come due within one year.
There are a number of ratios that measure accounting liquidity, which differ in how strictly they
define "liquid assets." Analysts and investors use these to identify companies with strong liquid ity.
It is also considered a measure of depth.

Liquidity Trap
Liquidity trap refers to a situation in which an increase in the money supply does not result
in a fall in the interest rate but merely in an addition to idle balances: the interest elasticity of
demand for money becomes infinite. Under normal conditions an increase in money supply,
resulting in excess cash balances, would cause an increase in bond prices, as individ ua ls
sought to acquire assets in exchange for money, and a corresponding fall in interest rates. In
such a situation, described by Keynes as liquidity trap, individuals believe that bond prices
are too high and will therefore fall, and correspondingly that interest rates are too low and
must rise. They, therefore, believe that to buy bonds would be to incur a capital loss and as a
result they hold only money. This means that an increase in the money supply merely
increases idle balances and leaves the interest rate unaffected.
Keynes pointed out that during depression when the rate of interest is very low, the demand
curve for money (or the liquidity preference curve) becomes completely elastic (horizonta l).
The rate of interest has fallen enough. It cannot fall further .The horizontal portion of the
liquidity preference curve is referred to as the liquidity trap. In this portion of the curve, the
demand for money is infinitely elastic with respect to the interest rate. Reductions in the
interest rate, in this portion only, increases people’s desire to hold cash balance. The
implication here is that any attempt to achieve the internal expansion through increased
investment brought about by lowering the interest rates would fall, because any increase in
the money supply created in order to reduce the rate of interest would be held in the form of
cash balances, making it impossible to use interest rates (monetary policy) to expand the
economy. See Fig. 7 which describes such a situatio n.

Keynes pointed out that the actual rate of interest cannot fall to zero because the expected
rate cannot fall to zero. People’s expectations play a very important role in altering the rate
of interest. Individuals’ views on the level of bond prices may be summarized in terms of
their views about the interest rate.
However, in practice, there is no statistical evidence to support the existence of a liquid ity
trap. Furthermore, while the hypothesis rests on the view that expectations are regressive it
offers no theory of precisely how these are formed.

Money Supply
The supply of money means the total stock of money (paper notes, coins and demand deposits of
bank) in circulation which is held by the public at any particular point of time. Supply of money
is only that part of total stock of money which is held by the public at a particular point of time. In
other words, money held by its users (and not producers) in spendable form at a point of time is
termed as money supply. There are four measures of money supply which are denoted by M1, M2,
M3 and M4. Measure of the
money supply, M or defined as currency and demand deposits with the public. This was in keeping
with the traditional and Keynesian views of the narrow measure of the money supply. Here M1 is
known as the narrow money and others are broad money.

M1
The money supply is typically through an “M” scale, where M0 includes the narrowest forms,
and M4 includes the broadest forms – M0/M1/M2/M3/M4. M1 is the money supply that is
composed of physical currency and coin, demand deposits, travelers' checks, other checkable
deposits, and negotiable order of withdrawal (NOW) accounts. M1 includes the most liquid
portions of the money supply because it contains currency and assets that either are or can be
quickly converted to cash. However, "near money" and "near, near money," which fall under
M2 and M3, cannot be converted to currency as quickly
Narrow money is a way of measuring and categorizing the money supply within an economy.
It includes specific kinds of money that are highly liquid. Due to its liquidity, it is easily
accessible and can be used for immediate spending. Some examples include cash or
checkable deposits. It is important to note that foreign currency, however, is not included in
narrow money. Narrow money can also be known as M1 e.g. notes and coins. M1 is a narrow
measure of the money supply that includes physical currency, demand deposits, traveler’s
checks, and other checkable deposits.M1 does not include financial assets, such as savings
accounts and bonds. The M1 is no longer used as a guide for monetary policy in the United
States due to the lack of correlation between it and other economic variables.M1 money is a
country’s basic money supply that's used as a medium of exchange. M1 includes demand
deposits and checking accounts, which are the most commonly used exchange mediums
through the use of debit cards and ATMs. Of all the components of the money supply, M1 is
defined the most narrowly. M1 does not include financial assets, such as savings accounts
and bonds. M1 money is the money supply metric most frequently utilized by economists to
reference how much money is in circulation in a country. The M1 money supply is composed
of Federal Reserve notes—otherwise known as bills or paper money—and coins that are in
circulation outside of the Federal Reserve Banks and the vaults of depository institutio ns.
Paper money is the most significant component of a nation’s money supply. For most central
banks, M1 almost always includes money in circulation and readily cashable instrume nts.
But there are slight variations on the definition across the world. For example, M1 in the
Eurozone also includes overnight deposits.

M2
M2 is a calculation of the money supply that includes all elements of M1 as well as "near
money." M1 includes cash and checking deposits, while near money refers to savings
deposits, money market securities, mutual funds, and other time deposits. These assets are
less liquid than M1 and not as suitable as exchange mediums, but they can be quickly
converted into cash or checking deposits.
M2 → M1 + Saving deposits with the post office Savings banks.

Broader concept of money supply than M1. M2 are money that you can withdraw and spend but
require greater effort.M2 is a measure of the money supply that includes cash, checking deposits,
and easily convertible near money.M2 is a broader measure of the money supply than M1, which
just includes cash and checking deposits.M2 is closely watched as an indicator of money supply
and future inflation, and as a target of central bank monetary policy.
 M3
M3 is a measure of the money supply that includes M2 as well as large time deposits,
institutional money market funds, short-term repurchase agreements (repo), and larger liquid
assets.
M3 → M1 + Time deposits with the banks. It is a broad concept of money supply.

It is thought that time deposit are not liquid as they cannot be withdrawn through drawing
cheque on them. However loans from banks can be obtained against these time deposits. Also,
they can be withdrawn at any time by forgoing some interest earned on them.
The M3 measurement includes assets that are less liquid than other components of the money
supply and are referred to as "near money," which are more closely related to the finances of
larger financial institutions and corporations than to those of small businesses and individua ls.
M3 is a collection of the money supply that includes M2 money as well as large time deposits,
institutional money market funds, short-term repurchase agreements, and larger liquid
funds.M3 is closely associated with larger financial institutions and corporations than with
small businesses and individuals.M3 was traditionally used by economists to estimate the
entire money supply within an economy and by governments to direct policy and control
inflation over medium and long-term periods. As a measure of money supply, M3 has largely
been replaced by money zero maturity (MZM).M3 is still published as a source of economic
data, but mostly for ease of historical comparisons.
1. The M3 classification is the broadest measure of an economy's money supply. It
emphasizes money as a store-of-value more so than as a medium of exchange,
hence the inclusion of less- liquid assets in M3. Less-liquid assets would includ e
those that are not easily convertible to cash and therefore not ready to use if
needed right away. In order to determine M3, each M3 component is given equal
weight during calculation. For example, M2 and large time deposits are treated
the same and aggregated without any adjustments. While this does create a
simplified calculation, it assumes that each component of M3 affects the
economy the same way, which is not the case in the actual economy.
2. This equal weighting can be considered a shortcoming of the M3 measureme nt
of the money supply, which is why it is no longer used as a true measurement of
the money supply any longer

M4
The technical definition of M4 includes private-sector retail bank and building society
deposits + Private-sector wholesale bank and building society deposits and Certificate of
Deposit.
M4 → M3+ Total deposits with Post Office Saving organization

Broad money e.g. M4 money supply is defined as a measure of notes and coins in circulatio n
(M0) + bank accounts. It is a broader definition because it includes bank accounts and not
just notes and coins in circulation. M4 is cash outside banks (i.e. in circulation with the public
and non-bank firms) plus private-sector retail bank and building society deposits plus private-
sector wholesale bank and building society deposits and certificates of deposit
While M1/M0 are used to describe narrow money, M2/M3/M4 qualify as broad money and
M4 represents the largest concept of the money supply. Broad money may include various
deposit- based accounts that would take more than 24 hours to reach maturity and be
considered accessible. These are often referred to as longer-term time deposits because their
activity is restricted by a specific time requirement
For M4, the broadest of the money supply definitions and the general outside limit for an
investment to be considered part of the money supply are those scheduled to mature in five
years or less. This duration, however, is not a strict definition. As with all levels of the money
supply, countries may classify their funds differently. For example, excluding M0 or M4 as
measures and considering the money supply as divided into the M1, M2, and M3 categorie s
only.

Money Demand
The demand for money is the total amount of money that a population of an economy wants
to hold. The three main reasons to hold money, as opposed to bonds, equity, or other financ ia l
asset classes, are as follows:
Money held for transactions

The amount of money held for such a reason is called transaction money balances.
Transaction money balances depend on several factors, but mainly:

• The overall conditions in the economy analyzed. When macroeconomic conditions

improve, in the form of higher nominal GDP growth, lower unemployment, or higher
salaries, it’s reasonable to assume that spending in the economy will improve. The
conditions determine an increase in the demand for money needed to finance the
purchase of goods and services.
• The citizens’ propensity to spend. Regardless of the overall macroeconomic
conditions, the citizens of an economy may possess a higher propensity to spend on
goods and services than another economy with similar characteristics, which would
create, other conditions held equal, a higher demand for money.

Money balances held for precautionary reasons

Precautionary money balances are held to moderate the impact of unexpected spending needs
that can occur in the future. The factors that drive the demand for precautionary money
balances are similar to those analyzed for transaction money balances.
• As the level of economic activity and GDP rises, companies and consumers will
increase the level of precautionary money balances for unforeseen spending needs.
 • The availability of credit and the level of interest rates affect the level of precautionar y
money balances. Other conditions held equal, when credit is easily (hardly) availab le
and interest rates are low (high), such money balances are expected to rise (decline).
• The balances held for precautionary reasons must be consistent with the level of
spending of a company, family, or individual. For example, a precautionary balance
of $500 would not be enough for a family that is spending $5,000 per month.

Money held for speculative reasons

Money held for speculative reasons is also known as the portfolio demand for money. The
money is held to take advantage of speculative opportunities or for covering/offsetting risks
in other assets or the economy. There are several cases in which money is used as a
speculative instrument:
• When there is deflation or when it is expected in the future. If prices decline, the
money stored today will be more valuable tomorrow.
• When conditions in other markets are not favorable and are expected to deteriorate.
For example, if the bond market doesn’t offer good returns, investors may prefer
holding speculative cash balances to wait for better market conditions. In addition, if
the prices of certain assets are expected to go down, investors may increase their cash
positions for speculative purposes.
• When people want to speculate on changes in currency rates. For example, if
somebody expects its domestic currency to depreciate significantly against a foreign
currency, they can buy the foreign currency and store it and wait for its appreciation
against the domestic currency, the strategy is known as hedging.

Post Office Savings

This account can be used to keep funds secure, withdraw cash, deposit money and perform easy
remittances, besides a host of other benefits. In addition, interest can be earned on the money kept
in this account and the cash withdrawals allowed in this account are unlimited It is a benefic ia l
scheme for individual investors who wish to earn a fixed rate of interest by investing a significa nt
portion of their financial assets.
The post office savings account is a deposit scheme provided by the post office througho ut
India. The account provides a fixed interest rate on the account balance. It is a beneficia l
scheme for individual investors who wish to earn a fixed rate of interest by investing a
significant portion of their financial assets. Post office savings account is also a very helpful
scheme for those residing in rural parts of India. Since the nationwide reach of the post offices
is much greater as compared to banks, a large number of unprivileged people have been able
to get access to savings accounts through post offices.
 Pritam Thapa
AEC-10M-2022

64. Demand Deposits

A demand deposit is money deposited into a bank account with funds that can be withdrawn on-
demand at any time. The depositor will typically use demand deposit funds to pay for everyday
expenses. For funds in the account, the bank or financial institution may pay either a low or zero
interest rate on the deposit.
In short, Demand deposits are accounts that allow people to withdraw money as and when required.
They are important in consumer spending, as the funds typically hold the money used in day-to-
day transactions. Common examples of demand deposits would be amounts in a checking or
savings account.
Importance of the Demand Deposit
i. Consumer spending
Demand deposits are important in consumer spending, as they hold the funds used to pay for
everyday expenses. The expenses may include groceries, transportation costs, personal care items,
and more. Demand deposits are, therefore, advantageous due to their liquidity and ease of access.
With the on-demand feature of demand deposits, people can withdraw money at any time
without the need to give the bank prior notice. Additional funds may be withdrawn from an ATM,
debit cards, the bank’s teller, or through written checks.
ii. Bank reserves
Demand deposits are important for institutions, as the total amount held in deposit accounts
determines the bank reserves that must be kept on hand. Bank reserves are held in the vault or on-
site at the bank and are essential in the case of large unexpected withdrawals.
The more money a bank holds in demand deposits, the more money it must keep in its bank
reserves. The money not kept in bank reserves is called excess reserves. Excess reserves are then
loaned out by banks, contributing to the money creation process.
iii. Money supply
Demand deposits are an important part of the money supply of a country, defined within M1
money. M1 money consists of currency plus demand deposits. Demand deposits make up a
significant part of the money supply in many countries.
During a financial crisis, many people together will make large withdrawals from the bank.
The withdrawals will lead to a decline in demand deposits and a decrease in the money supply,
with banks left with less money to loan out.
Types of Demand Deposits
There are three common types of demand deposits which are as follows:
i. Savings account
You must be quite familiar with a savings account. This is a type of demand deposit account or
DDA which holds the funds for a long duration and has a minimum required balance so almost
everyone can open a savings account. In addition to that if you put a larger amount of money in
your savings account, it gives a higher interest.
ii. Checking account
This is another most common type of demand deposit account or DDA. These accounts offer a
high liquidity which allows the money to be withdrawn at any time when required. These accounts
earn a very low interest or no interest at all. When earned, the interest depends upon the financ ia l
provider. These accounts are generally for a short-term use as opposed to the savings accounts
which are long term.
iii. Money Market Account
This account is specifically for the demand deposits that follow the market interests. The market
interest rates are affected by the economic activity of the central banks. Therefore, the interest
provided by the money market accounts depends on the market interest rate and it can be either
less or more than that provided by the savings account.

65. Interest:
Interest is a payment made by a borrower to the lender for the money borrowed and is expressed
as a rate percent per year.
Prof. Marshall has said – “The payment made by borrower for the use of a loan is called Interest.”
Prof. Keynes has said – “Interest is the reward of parting with liquidity for a specified period.”
Modern economist in order to avoid the divergent and controversial views about Interest, have
explained it in terms of productivity, saving, liquidity and money. In other words, Interest is the
reward for the yield of capital, of saving, for the foregoing of liquidity and the supply of money.
Two types of Interest:
Gross Interest and Net Interest:
Gross Interest:
Gross Interest is the payment made by the borrowers to the lenders is called Gross Interest or
Composite Interest.
Net Interest:
Net Interest is the earnings of capital simply or the reward of waiting simply.
Net Interest = Gross Interest – (payment for risk + payment for inconvenience + cost of
administering credit)
i.e., Net Interest = Net Payment for the use of capital.
Simple Interest and Compound Interest:
Simple Interest: Simple interest can be defined as the principal amount of a loan or deposit a
person makes into their bank account.
The formula for simple interest is given by:
SI = (P x R x T)/100
where SI = Simple Interest
P = Principal Amount
R = Rate of interest
T = Time duration in years
Compound Interest: Compound interest is the interest that accumulates and compounds over the
principal amount.
The formula for compound interest is given by:
CI = Amount – Principal
and Amount = P(1+R/100)t
Interest and Macroeconomics:
A low-interest-rate environment is intended to stimulate economic growth so that it is cheaper to
borrow money. This is beneficial for those who are shopping for new homes, simply because it
lowers their monthly payment and means cheaper costs. When the Federal Reserve lowers rates,
it means more money in consumers' pockets, to spend in other areas, and more large purchases of
items, such as houses. Banks also benefit from this environment because they can lend more
money.
However, low-interest rates aren't always ideal. A high- interest rate typically tells us that the
economy is strong and doing well. In a low-interest-rate environment, there are lower returns on
investments and in savings accounts, and of course, an increase in debt which could mean more of
a chance of default when rates go back up.
66. Bonds:
Bonds are special component of capital market, which are specific type of security sold by
government or corporation to raise the fund for long term. In return for buying the bond and
investor gets a certain interest rate for the duration of the bond. Interest, income stream and all
other features of bonds are earlier explained in Bond details which include the end date when the
principal of the loan is due to be paid to the bond owner and usually include the terms for variable
or fixed interest payments made by the borrower.
Most bonds share some common basic characteristics including:
i. Face value (par value) is the money amount the bond will be worth at maturity; it is also the
reference amount the bond issuer uses when calculating interest payments. For example, say an
investor purchases a bond at a premium of $1,090, and another investor buys the same bond later
when it is trading at a discount for $980. When the bond matures, both investors will receive the
$1,000 face value of the bond.
ii. The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond,
expressed as a percentage.
For example, a 5% coupon rate means that bondholders will receive 5% x $1,000 face value =
$50 every year.
iii. Coupon dates are the dates on which the bond issuer will make interest payments. Payments
can be made in any interval, but the standard is semiannual payments.
iv. The maturity date is the date on which the bond will mature and the bond issuer will pay the
bondholder the face value of the bond.
v. The issue price is the price at which the bond issuer originally sells the bonds. In many cases,
bonds are issued at par.
Two features of a bond credit quality and time to maturity are the principal determina nts
of a bond's coupon rate.
The major classes of bond issuers are the government, corporations, and municipal governme nts.
The default risk and tax status differ from one kind of bond to another.
Types of Bonds:
i. Corporate bonds: are debt securities issued by private and public corporations.
ii. High-yield: These bonds have a lower credit rating, implying higher credit risk, than
investment- grade bonds and, therefore, offer higher interest rates in return for the increased risk.
iii. Municipal bonds: called “munis,” are debt securities issued by states, cities, counties and other
government entities.
Risk to investor associated with Bond are:
Credit risk: The issuer may fail to timely make interest or principal payments and thus default on
its bonds.
Interest rate risk: Interest rate changes can affect a bond’s value. If bonds are held to maturity
the investor will receive the face value, plus interest. If sold before maturity, the bond may be
worth more or less than the face value. Rising interest rates will make newly issued bonds more
appealing to investors because the newer bonds will have a higher rate of interest than older ones.
To sell an older bond with a lower interest rate, you might have to sell it at a discount.
Inflation risk: Inflation is a general upward movement in prices. Inflation reduces purchasing
power, which is a risk for investors receiving a fixed rate of interest.
Liquidity risk: This refers to the risk that investors won’t find a market for the bond, potentially
preventing them from buying or selling when they want.
Call risk: The possibility that a bond issuer retires a bond before its maturity date, something an
issuer might do if interest rates decline, much like a homeowner might refinance a mortgage to
benefit from lower interest rates.

67. Shares:
A stock, also known as equity, is a security that represents the ownership of a fraction of the issuing
corporation. Units of stock are called "shares" which entitles the owner to a proportion of the
corporation's assets and profits equal to how much stock they own.
A share is an indivisible unit of capital, expressing the ownership relationship between the
company and the shareholder. The denominated value of a share is its face value, and the total of
the face value of issued shares represent the capital of a company, which may not reflect the market
value of those shares. The income received from the ownership of shares is a dividend. There are
different types of shares such as equity shares, preference shares, deferred shares, redeemable
shares, bonus shares, right shares, and employee stock option plan shares.
Companies invest in raising funds from investors. They also allow stakeholders a stake in the
company’s profit. Investing in shares gives better returns on investment than traditional investme nt
options and can help compound wealth in the long-run.
Valuation of shares:
Shares are valued according to the various principles in different markets, but a basic premise is
that a share is worth the price at which a transaction would be likely to occur were the shares to be
sold. The liquidity of markets is a major consideration as to whether a share is able to be sold at
any given time. An actual sale transaction of shares between buyer and seller is usually considered
to provide the best prima facie market indicator as to the true value of shares at that particular time.
For examples; suppose if the market capitalization of a company is Rs 10 lakh, and a single share
is priced at Rs. 10 then the number of shares to be issued will be 1 lakh.
Types of shares
i. Preference shares
It is the type of shares that gives certain preferential rights as compared to other types of share.
The main benefits that preference shareholders have are:
They get first preference when it comes to the payout of dividend, i.e. a share of the profit earned
by the company.
When the company winds up, preference shareholders have the first right in terms of getting repaid.
The three sub-types of preference share are:
• Cumulative preference share: Shareholders have the right to receive arrears on dividend
before any dividends is paid to equity shareholders. For example, if the dividend on
 preference shares for year 2020 and 2021 has not been paid due to market downturns,
preferential shareholders are entitled to receive dividend for all preceding years in addition
to the current one.
• Non- cumulative shares: Shareholders cannot claim any outstanding dividend. These
shareholders only earn a dividend when the company earns profits. No dividends are paid
for the prior years.
• Convertible preference shares: These shares are convertible. Convertible shareholders can
convert their preference shares into equity shares at a specified period of time. However,
the conversion of shares will need to be authorized by the Articles of Association of the
company.
ii. Equity shares
It is also known as ordinary shares. The majority of shares issued by the company are equity shares.
This type of share is traded actively in the secondary or stock market. These shareholders have
voting rights in the company meetings. They are also entitled to get dividends declared by the
board of directors. However, the dividend on these shares is not fixed and it may vary year to year
depending on the company’s profit.
iii. Differential voting right shares
The DVR shareholders have less voting rights compared to equity shareholders. To dilute the
voting privileges, companies provide extra dividend to DVR shareholders. As DVR have less
voting rights their prices are also low. The price gap between equity shares and DVR shares is
almost 30-40%

68. Money market:

Financial Market refers to the marketplace where creation and trading of financial assets, such as
shares, debentures, bonds, derivatives etc. takes place. Two types of Financial market are Money
market and Capital market.
Money market refers to a section of financial market where financial instruments with high
liquidity and short-term maturities are traded.
The Money market is a market for lending and borrowing of short-term funds. It deals in
funds and financial instruments having a maturity period of one day to one year. It covers money
and financial assets that are close substitutes for money.
Instruments of Money Market:
The tools which are operating in the money market are money market instruments. Highly
liquid, safe, and discount pricing are the major characteristics of money market instruments.
The money market of the world is great and there are several instruments of money market,
Common five types of instrument are as follows:
i). Treasury Bills
T-bonds are the government bond or securities issued by the central government with a
maturity of less than one year. Treasury bills are also known as with T-Bills. It is the instrume nt
used by the government to raise money for short-term purposes. This is the safest investment with
negligible risk.
The date and the number of T-Bills are predetermined by the central government. There
are four types of treasury bills which are: 28 days, 91 days T-Bills, 182 days T-Bills, and 364 days
T-Bills. No tax deducted at source, risk-free investment, transparency, and good return is the major
advantage of T-Bills. T-Bills issued with less value than their face value.
2. Certificate Deposits
Certificate Deposits (CDs) issued by banks with certain interest rates and times. CDs used by
commercial banks as a negotiable instrument. Certificate deposits issued through the promissory
note. The CDs can be issued to individuals, companies, and investment companies.
Therefore, it is a fixed interest income instrument governed by the central bank. Security,
high-interest rates, flexibility, and low to minimum maintenance costs are the major advantages of
certificate deposits. Although its CDs sound like Fixed Deposit (FD), there are certain differences .
CDs are freely negotiable instruments however, FD is not.
3. Commercial Papers
Commercial papers (CPs) will issue to meet the capital requirement of the particular company. So,
CPs are the short-term debt issued by the banks or the company to finance inventories and
temporary liabilities. CPs are short-term debts that have maturity no longer than 270 days.
Secured and Unsecured securities are two types of commercial papers. Therefore, the issuer
fixed the amount payable to the buyer in the future in terms of liquid. So, it is a short-term debt
including promissory notes with set maturity.
4. Repurchase Agreements (Repo)
In some markets, Repo also known as a sale and repurchase agreement. Repo is a collateralized
loan. The central bank fixes the repo rate and uses it wisely to regulate the money supply. It is an
essential tool of Monetary Policy. So, Repo is a short-term instrument, where a seller sells
government security to a buyer with the agreement of repurchase. Term and open repurchase are
the major types of Repo.
5. Banker’s Acceptance
Banker’s Acceptance (BAs) is a piece of paper with promising future payment guaranteed by a
bank. BAs are popular within commercial banks. In BAs form, many details include the amount
need to repaid, repayment date, and individual’s details to which the repayment is due. The
maturity period of Banker’s Acceptance is from 30 days to 180 days.
Except for treasury bills, other money market instruments are not popular in Nepal. The money
market is still very narrow in Nepal. The money market instruments like commercial papers,
certificates of deposits, banker’s acceptance, and call money are not traded in Nepal.
Only Nepal Rastra Bank and commercial banks are the players in the money market of Nepal.
There are no individuals and other companies involved in the money market of Nepal. The NRB
and ‘A’ level banks traded T-Bills and inter-bank borrowing.
To develop the money market in Nepal, Nepal Rastra Bank should play a crucial role by
developing different instruments, raising awareness, supervise properly, and making the market
more accessible.

69. Capital Market:

Capital Market is a market place where buyers and sellers engage in trade of a financia l market in
which long term debt (more than one year) or equity-backed securities are bought and sold. Major
securities traded in Nepal are Equity shares, Preference shares, Mutual Funds and Debentures.
Capital market helps to raise the long-term funds-both equity and debt-and funds raised within and
outside the country. It aids economic growth by mobilizing the savings and directing the same
towards productive use.
In Nepal, NEPSE, Central Depository Services & Clearings Ltd, listed companies, Securities
Broker, Depository participants, Merchant Banks, Institutional Investors and Individual investors
are the players of the capital market. Now security dealers is also about to enter Capital market
soon.
Features/Characteristics of Capital Market:
• Link between savers and investors
• Deals in Long Term fund
• Utilizes Intermediaries (like: Brokers, underwriters, depositories)
• Capital Formation
• Capital market operates freely but under the guidance of government policies
Importance of Capital Market:
• Link between savers and investors
• Basis for industrialization and economic growth
• Accelerating the pace of growth
• Generating Liquidity
• Increase the national income
• Capital Formation
• Productive Investment
Types of Capital Market:
i. Primary Market
Primary market is the market for new shares or securities. A primary market is one in which a
company issues new securities in exchange for cash from an investor (buyer). It deals with trade
of new issues of stocks and other securities sold to the investors.
 In the primary market, the securities are issued by either Initial Public Offer (IPO), Further Public
Offer (FPO), Right Share and Bonus Share
ii. Secondary Market
Secondary market deals with the exchange of prevailing or previously-issued securities among
investors. Once new securities have been sold in the primary market, an efficient manner must
exist for their resale. Secondary markets give investors the means to resell/ trade existing
securities. Another important division in the capital market is made on the basis of the nature of
security sold or bought, i.e. stock market and bond market.
In secondary market, investors trade the existing securities through Nepal Stock Exchange
(NEPSE)

70.Labour Market:
A labour market is the place where workers and employees interact with each other. In the labour
market, employers compete to hire the best, and the workers compete for the best satisfying job.
A labour market in an economy function with demand and supply of labour. In this market,
labour demand is the firm's demand for labour and supply is the worker's supply of labour. The
supply and demand of labour in the market is influenced by changes in the bargaining power.
Labor market performance differs in the microeconomic and macroeconomic theories;
microeconomics theory examines the labor demand and supply at an independent employee and
employer level, individual firms interact with employees, hiring them, firing them, and raising or
cutting wages and hours. The relationship between supply and demand influences the number of
hours employees work and the compensation they receive in wages, salary, and benefits.
In contrast, the macroeconomics theory reviews the connection between commodities, jobs, the
foreign exchange market, and cash. The macroeconomic view of the labor market can be diffic ult
to capture, but a few data points can give investors, economists, and policymakers an idea of its
health. The first is unemployment. During times of economic stress, the demand for labor lags
behind supply, driving unemployment up. High rates of unemployment exacerbate economic
stagnation, contribute to social upheaval, and deprive large numbers of people of the opportunity
to lead fulfilling lives.

Labour Market Component:

Four Components:
i.Manpower Participation: No. of people available to work in the job market
ii.Candidate Population: Individuals applying for a specific job
iii.Candidate Pool: No. of individuals revealing interest by resume submission
iv.Appointed individuals: Candidates selected for the position
Labour Market Equilibrium:
Labor market graph exhibits an equilibrium position where the labor quantity and cost are balanced
and unaffected, except in serious circumstances. Most importantly, the employers are considered
sellers while the workforce is conceived as buyers.

According to the macroeconomic theory, the fact that wage growth lags productivity growth
indicates that the supply of labor has outpaced demand. When that happens, there is downward
pressure on wages, as workers compete for a scarce number of jobs and employers have their pick
of the labor force.
Conversely, if demand outpaces supply, there is upward pressure on wages, as workers have more
bargaining power and are more likely to be able to switch to a higher paying job, while employers
must compete for scarce labor.
The five factors affecting the labor market are:
i. Labor supply and demand
ii. Economic regeneration initiatives
iii. Minimum wage policies
iv. Education and instructional programs, and
v. Working populace
 Ganga Lamichhane

AEC-11M-2022

1. Policies
Policy is a deliberate system of guidelines to guide decisions and achieve rational outcomes.
A policy is a statement of intent and is implemented as a procedure or protocol. Policies are
generally adopted by a governance body within an organization.

A sound business policy should possess the following characteristics:

Flexibility: A policy must be flexible and the usual words which are added in the policy to
make it flexible are “whenever possible”, “as the case may be”, “under usual conditions” etc.,
It should provide for discretion so that subordinate manager can intelligently apply the policy
in a given situation. A rigid policy serves no purpose.
Easily understandable: A policy should be such that everyone in the organization understands
it. It should therefore, be stated in definite, positive and clear terms. There will be no problem
in the implementation of policy which is definite, simple, clear and easily understandable.
Precise and Written: A policy should be precise and written so that all people understand it
in the same sense. It is not an easy thing to write a policy. Policies can also be oral but written
policies are of great help to the subordinate staff.
Consistent: There must be a consistency of sectional policies with the main policy. If policies
are inconsistent or contradictory, it will lead to confusion at the subordinate level. Thus
different policies of the company should be in harmony with each other. It should also be
consistent with the public policy.
Fair and Equitable: A policy should conform to economic principles, business laws, equity
and justice. It must be fair to those who are affected by it, and should be in accordance with
the accepted business standards. It should be formulated with due regard to the interests of all
the concerned parties. i.e., the employer, the employee and the public.
Practicable: A policy should be such that it is actually possible to implement it in real business
situations. Thus a policy should be founded upon facts, and sound judgement.
Stable: Although some amount of flexibility in a policy is desirable yet, it is one of the basic
characteristics of a policy that it should be stable. If the concept of flexibility is taken to mean
as frequent changes in a policy, the very objective of a policy is defeated.
Review: On account of the dynamic nature of business, it is necessary to review the policies
at frequent intervals. A decision is then taken as to whether the policies are to be modified,
changed or replaced by a new policies.
2. Monetary policies
Monetary policy is the control of the quantity of money available in an economy and the
channels by which new money is supplied. By managing the money supply, a central bank
aims to influence macroeconomic factors including inflation, the rate of consumptio n,
economic growth, and overall liquidity. In addition to modifying the interest rate, a central
bank may buy or sell government bonds, regulate foreign exchange (forex) rates, and revise
the amount of cash that the banks are required to maintain as reserves.
Economists, analysts, and investors eagerly await monetary policy decisions and even the
minutes of meeting in which they are discusses. This is news that has a long-lasting impact on
the overall economy as well as on specific industry sectors and markets.
Monetary policy is formulated based on inputs from a variety of sources. The monetary
authority may look at macroeconomic numbers such as gross domestic product (GDP) and
inflation, industry and sector-specific growth rates, and associated figures.
The central bank may also consider concerns raised by groups representing specific industr ies
and businesses, survey results from private organizations, and inputs from other governme nt
agencies. In Nepal Nepal Rastra Bank (NRB) is in charge of monetary policy.
Broadly speaking, monetary policies can be categorized as either expansionary or
contractionary:
• Expansionary monetary policy: If a country is facing high unemployment due to a
slowdown or a recession, the monetary authority goes for an expansionary policy aimed at
increasing economic growth and expanding economic activity. As a part of expansionar y
policy, the monetary authority often lowers the interest rates in order to promote spending
money and make saving it unattractive.
• Contractionary monetary policy: A contractionary monetary policy increases interest rates
in order to slow the growth of the money supply and bring down inflation. This can slow
economic growth and even increase unemployment but is often seen as necessary to cool down
the economy and keep prices in check.
Tools to implement monetary policy: Central banks use a number of tools to shape and
implement monetary policy
• First is the buying and selling of short-term bonds on the open market using newly created
bank reserves. The central bank adds money into the banking system by buying assets or
removes it by selling assets.
• The second option is to change the interest rates or the required collateral that the central
bank demands for emergency direct loans to bank in its role as lender of last resort.
• Unconventional monetary policy has also gained popularity in recent times. During periods
of extreme economic turmoil, such as the financial crisis of 2008, the U.S. fed loaded its
balance sheet with trillions of dollars in treasury notes and mortgage backed securities,
introducing new lending and asset purchase program that combined aspects of discount
lending, open market operations.
 3. Fiscal policies
Fiscal policy is the use of government spending and taxation to influence the
economy. Governments typically use fiscal policy to promote strong and sustainable growth
and reduce poverty. When policymakers seek to influence the economy, they have two main
tools at their disposal—monetary policy and fiscal policy. Fiscal policy that increases
aggregate demand directly through an increase in government spending is typically called
expansionary or “loose.” By contrast, fiscal policy is often considered contractionary or “tight”
if it reduces demand via lower spending. (Horton and El-Ganainy, 2020)
There are two types of fiscal policy:
Expansionary fiscal policy: This policy is designed to boost the economy. It is mostly used
in times of high unemployment and recession. It leads to the government lowering taxes and
spending more, or one of the two. The aim is to stimulate the economy and ensure consumers'
purchasing power does not weaken.
Contractionary fiscal policy: As the term suggests, this policy is designed to slow economic
growth in case of high inflation. The contractionary fiscal policy raises taxes and cuts
spending.
There are two key tools of the fiscal policy:
Taxation: Funds in the form of direct and indirect taxes, capital gains from investment, etc,
help the government function. Taxes affect the consumer's income and changes in consumptio n
lead to changes in real gross domestic product (GDP).
Government spending: It includes welfare programmers, government salaries, subsidies,
infrastructure, etc. Government spending has the power to raise or lower real GDP, hence it is
included as a fiscal policy tool. The fiscal policy helps mobilize resources for financ ing
projects. The central theme of fiscal policy includes development activities like expenditure
on railways, infrastructure, etc. Nondevelopment activities include spending on subsidies,
salaries, pensions, etc. Fiscal policy aims to minimize income and wealth inequalities. It gives
incentives to the private sector to expand its activities. It aims to reduce the deficit in the
balance of payment.

4. Say’s law
Say’s law states that the production of good creates its own demand. According, to French
economists Jean- Baptise it is a classical economic theory that says that the income generated
by past production and sales of goods is the source of spending that created demand to purchase
current production. Say’s Law implies that production is the key to economic growth and
prosperity and the government policy should encourage (but not control) production rather
than promoting consumption.
Say’s law of markets was developed in 1803 by the French classical economist and journalist,
Jean-Baptise Say. Say was influential because his theories address how a society creates wealth
and the nature of economic activity. To have the means to buy, a buyer must first have sold
something, Say reasoned. So, the source of demand is prior to the production and sale of goods
for money, not money itself. In other words, a person’s ability to demand goods or services
from others is predicted on the income produced by that person’s own past acts of production.
Say’s law ran counter to the mercantilist view that money is the source of wealth. Under Say’s
Law, money functions solely as a medium to exchange the value of previously produced goods
for new goods as they are produced and bought to market, which by their sale then, in turn,
produce money income that fuels demand to subsequently purchase other goods in an ongoing
process of production and indirect exchange.
According to Say’s law, a deficiency of demand for a good in the present can occur from a
failure of the production of other goods rather than from a shortage of money. However, he
pointed out that the scarcity of some goods and glut of others can persist when the breakdown
in production is perpetuated by ongoing natural disaster or government interference. Say’s law
support the view that government should not interfere with the free market and should adopt
Laissez-faire economics.
Implication of Say’s law
• The greater the number of producers and a variety of products in an economy, the more
prosperous it will be. Conversely, those members of a society who consume and do not produce
will be a drag on the economy.
• The success of one producer or industry will be benefit other producers and industries whose
output they subsequently purchase, and businesses will be more successful when they locate
near or trade with other successful business. This also means that government policy that
encourages production, investment, and prosperity in neighbouring countries will redound to
the benefit of the domestic economy as well.
• The importation of goods, even at a trade deficit, is beneficial to the domestic economy.
• The encouragement of consumption is not beneficial, but harmful, to the economy. The
production and accumulation of goods over time constitutes prosperity; consuming without
producing eats away the wealth and prosperity of an economy. Good economic policy should
consist of encouraging industry and productive activity in general, while leaving the specific
direction of which goods to produce and how up to investors, entrepreneurs, and workers in
accord with market incentives.
Criticisms of Say’s Law
• The mass unemployment and prolonged recession of the 1930s suggested that production
does not equal demand. In a recession, there can be insufficient aggregate demand for goods
produced.
• Price and wages are not flexible. eg. Workers may resist nominal wage cuts.
• Excess savings. There are examples where there is an increase in savings, and business ma n
and consumers hoard cash.
• Liquidity trap. In a liquidity trap, the demand to hold cash is greater than the demand to spend.
Banks increase their reserves and the saving rate increases, this leads to a fall in aggregate
demand.
 • Confidence. In certain circumstances, people may not have the confidence to spend and
invest. They may become risk averse and hoard cash in unproductive savings.
• It may be very rational to ‘hoard’ money- especially in a period of deflation or anxiety.
• The balance sheet recession of 2008-12, illustrated an example of where banks, consumers
and firms were keen to pay off their debts and not spend all their income. This led to a
prolonged recession.
Example of say’s law
Say’s law can be understood in terms of a barter economy. A woodworker, for example,
produces or supplies furniture as a means of buying or demanding the food and clothing
produced by other workers. The woodworker’s supply of furniture is the income that he will
“spend” to satisfy his demand for other goods. The goods he buys will have a total value exactly
equal to the goods he produces. And so it is for other produces and for the entire economy.
Demand must be same as supply.

5. Quantity theory of money

Monetary economics is a branch of economics that studies different theories of money. One of
the primary research areas for this branch of economics is the quantity theory of money (QTM).
According to the quantity theory of money, the general price level of goods and services is
proportional to the money supply in an economy—assuming the level of real output is constant
and the velocity of money is constant.
It is supported and calculated by using the Fisher Equation on Quantity Theory of Money. Also
known as equation of exchange
M*V= P*T
Where, M = Money supply
P = Price level
V = Velocity of money in circulation or number of times money changes hand
T = volume of the transactions
According to the quantity theory of money, if the amount of money in an economy double, all
else equal, price levels will also double. This means that the consumer will pay twice as much
for the same amount of goods and services. This increase in price levels will eventually result
in a rising inflation level. The same forces that influence the supply and demand of any
commodity also influence the supply and demand of money: an increase in the supply of money
decreases the marginal value of money–in other words, when the money supply increases, but
with all else being equal or ceterius paribus, the buying capacity of one unit of currency
decreases. As a way of adjusting for this decrease in money's marginal value, the prices of
goods and services rises; this results in a higher inflation level. The theory is accepted by most
economists per se. However, Keynesian economists and economists from the Monetarist
 School of Economics have criticized the theory. According to them, the theory fails in the short
run when the prices are sticky. Moreover, it has been proved that velocity of money doesn't
remain constant over time. Despite all this, the theory is very well respected and is heavily
used to control inflation in the market.

6. Velocity of money
The velocity of money is a measurement of the rate at which money is exchanged in an
economy. It is the number of times that money moves from one entity to another. It also refers
to how much a unit of currency is used in a given period of time. Simply put, it's the rate at
which consumers and businesses in an economy collectively spend money. The velocity of
money is usually measured as a ratio of gross domestic product (GDP) to a country's M1 or
M2 money supply. • The velocity of money formula shows the rate at which one unit of money
supply currency is being transacted for goods and services in an economy. • The velocity of
money is typically higher in expanding economies and lower in contracting economies.
Economists use the velocity of money to measure the rate at which money is used for goods
and services in an economy. While it is not necessarily a key economic indicator, it can be
followed alongside other key indicators that help determine economic health like GDP,
unemployment, and inflation. GDP and the money supply are the two components of the
velocity of money formula. Economies that exhibit a higher velocity of money relative to
others tend to be more developed. The velocity of money is also known to fluctuate with
business cycles. When an economy is in an expansion, consumers and businesses tend to more
readily spend money causing the velocity of money to increase. When an economy is
contracting, consumers and businesses are usually more reluctant to spend and the velocity of
money is lower. The velocity of money is calculated by dividing a country's gross domestic
product by the total supply of money. This calculation can use either the M1 money supply,
which includes physical currency, checkable deposits, and certain other figures, or the M2
supply, which also includes savings deposits and money market funds.

7. Price level
General Price level also called as Price Level is the average of the current prices of the goods
and services produced in an economy. It is expressed in small ranges or as discrete values such
as dollar figures (Kenton, 2020). The changes in price level creates inflation and deflatio n
which has a great impact in the economy of a nation. Increase in the average level prices known
as inflation while deflation refers to decrease in the average level of prices in an economy
(Principle of Economics: Price Level Changes, 2011).
Importance:
• Key indicator of inflation and deflation
• Plays important role in purchasing power of consumers as well as the sale of goods and
services
 • Used in supply-demand chain.
How to measure?
Price index is used to measure the price level. It is a number which changes reflects the
movement in price level usually expressed as percentage rate of change in the price level. For
example, if the price index rises by 5% then, it indicates that the average price level is increased
by 5%. According to Principle of Economics: Price Level Changes, 2011, following steps are
followed for calculation of price level:
Step 1: Preparation of market basket. A market basket is the list of goods and services that we
want to include in the price index.
Step 2: Computation of prices of market basket in some period which will be the base period
of price index. A base period is the time period with which other periods are compared using
price index. Generally, it is of single year. For example, if we select the year 2015 as base
period then, we compared costs of basket of other years with the year 2015.
Step 3: Compute the prices of market basket in current period.
Step 4: Calculation of price index as:
Price index = (current cost of basket / base period cost of basket) *100%
 Amrita Paudel
AEC-12M-2022

1. Rigid wage
The adjustment of the wages in response to the economic environment is important in
shaping labor markets. If wages exceed market clearance level and are rigid downward,
involuntary unemployment can rise (Goette, Sunde, & Bauer, 2007).
Downward rigidity means wages are difficult to fall when the economy is bad. Ideally,
businesses cut wages during a recession as the unemployment rate rises. Upward rigidity means
wages do not rise immediately following the situation in the labor market. As the economy
recovers toward expansion, the demand for labor increases. However, businesses did not
immediately raise wages in response to a tighter labor market
A company experiences the general difficulty in trying to reduce wages of a labor. Because
of a labor agreement or fears for lost productivity or any other reasons, companies usually find it
hard to reduce employee wages. And this nature of wage to be stable and not falling is called the
rigid wage. For this reason, many companies choose to discharge their labors rather than reducing
wage when facing losses or lower profits. Sticky/ Rigid wage theory argues that employee pay is
resistant to decline even under deteriorating economic conditions. This is because workers will
fight against a reduction in pay, and so a firm will seek to reduce costs elsewhere, including firing
of the laborers, if profitability falls. Wage rigidity, or the inability to move wages lower, has
significant ramifications for labor markets and macroeconomic performance.
For example, companies are reluctant to reduce wages during a recession because they are
under contract. Thus, they do not arbitrarily cut wages to lower costs and increase profitability. On
the other hand, workers are reluctant to accept wage cuts during a recession. They may threaten to
strike if the company lowers wages. They can carry out these threats because they have strong
bargaining power, for example, because they are labor union members (Nasruin, 2022).

2. Real wage
Real wages are wages adjusted for inflation, or, equivalently, wages in terms of the amount
of goods and services that can be bought (Wikipedia ). Real wages are the wages which are
adjusted for inflation and provide a clearer representation of an individual's wages in terms of what
they can afford to buy with those wages (Pettinger, 2022).
Since the amount of inflation itself is not well defined because of change in relative prices,
real wages suffer the disadvantage of not being well defined. Real wages are a guide to how living
standards have changed. The standard of living and the prosperity of a laborer depend on his real
wages. The amount of compensation a person can anticipate earning after factoring in the current
inflation rate is known as the real wage, or adjusted wage. If a person’s nominal wage is $12.00,
their real wage will be higher or lower based on the current rate of inflation. In this case, a low
inflation rate means that a person’s $12.00 per hour wage will buy them more than if they were
paid $12.00 per hour during a period of high inflation (Career development: Indeed, 2020).

Real wage = Nominal wage - (Nominal wage x Inflation rate)

3. Money wage
Workers supply labor service in the production process and for this they get wages. Money
wages are always expressed in terms of money. It is also called nominal wage. Suppose an
employee is employed at a monthly wage rate of 500 dollars. Here 500 dollars represents a nomina l
wage rate. Nominal wages don't have a calculation or formula.
Nominal or money wages are the payments done to workers in money form and do not take
account of inflation rates and any other market conditions. Money wages do not take into
consideration the purchasing power and the employee receives the amount that is promised to him
when he/she is hired.
The basis determination of nominal wage would be the government regulations and the
organization’s compensation policy within its capacity. Money wages is just the payment done for
labor done within an organization. Money wages however, don’t consider inflation and any market
conditions. It is mostly determined by the government set regulations such as minimum wages
(Konig, 1990).

4. Central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and
monetary policy of a country or monetary union, and oversees their commercial banking system
(Central Bank:Wikipedia). In contrast to a commercial bank, a central bank possesses a monopoly
on increasing the monetary base. Most central banks also have supervisory and regulatory powers
to ensure the stability of member institutions, to prevent bank runs, and to discourage reckless or
fraudulent behavior by member banks.
Central banks in most developed nations are institutionally independent from political interfere nce
(Oritani, 2010). Still, limited control by the executive and legislative bodies exists (Central
Bank:Wikipedia).

Functions of a central bank usually include:

• Monetary policy: by setting the official interest rate and controlling the money supply;
• Financial stability: acting as a government's banker and as the bankers' bank ("lender of
last resort");
• Reserve management: managing a country's foreign-exchange and gold reserves and
government bonds;
• Banking supervision: regulating and supervising the banking industry;
• Payments system: managing or supervising means of payments and inter-banking clearing
systems;
• Coins and notes issuance;
• Other functions of central banks may include economic research, statistical collectio n,
supervision of deposit guarantee schemes, and advice to the government in financial policy.
5. Credit
Credit is the ability to borrow money or access goods or services with the understanding
that you'll pay later (Clarine, 2022). Credit is generally defined as a contract agreement in which
a borrower receives a sum of money or something of value and repays the lender at a later date,
generally with interest (Clarine, 2022). Credit also may refer to the creditworthiness or credit
history of an individual or a company.
To an accountant, it refers to a bookkeeping entry that either decreases assets or increases
liabilities and equity on a company's balance sheet. So, a credit increases net income on the
company's income statement, while a debit reduces net income. Credit refers to an agreement to
purchase a product or service with the express promise to pay for it later. This is known as buying
on credit. The most common form of buying on credit today is via the use of credit cards. This
introduces a middleperson to the credit agreement: the bank that issued the card repays the
merchant in full and extends credit to the buyer, who may repay the bank over time.
Types of Credit:
a. Revolving credit: In this, you are given a maximum borrowing limit, and you can make
charges up to that limit where you must make a minimum payment each month. Most credit cards
count as revolving credit.
b. Charge cards: Charge cards are used in much the same way as credit cards, but they don't
permit you to carry a balance: You must pay all charges in full every month.
c. Service credit: All the service providers such as gas and electric utilities, cable and internet
providers, etc. provide their services with the understanding that we will pay for them after the
fact.
d. Installment credit: Installment credit is a loan for a specific sum of money you agree to
repay, plus interest and fees, in a series of equal monthly payments (installments) over a set period
of time. Student loans, car loans and mortgages are all examples of installment credit

Importance of credit:
• Credit is tool that can help you buy things you need now and pay for them over time.
Establishing and building up good credit over time is an important element of sound financ ia l
health.
• Landlords may check your credit when deciding if they'll rent you an apartment or determining
how large a security deposit to require.
• Insurance companies may use your credit scores as factors in determining your rates. • Utility
companies may check your credit before deciding to let you open an account or borrow
equipment.
• Prospective employers may use information found in credit reports to make a hiring decision.
• Your credit report can even be used to verify your identity, and for other purposes defined by
federal law.
6. Marginal efficiency of capital
Marginal efficiency of capital refers to the rate of profit expected to be made from
investment in certain capital assets. According to Keynes, investment demand depends upon two
factors: (1) Expected rate of profits to which Keynes gives the name Marginal Efficiency of Capital
and (2) the rate of interest (Magadh).
For example, if a businessman spends $10,000 on the purchase of a new grading
machine. We assume further that this new capital asset continues to produce goods over a long
period of time. The net return (excluding meeting all expenses except the interest cost) of the
grading machine is expected to be $1000 per annum. The marginal efficiency of capital will be
10%. (1000/10000) Χ (100/1) = 10%
Formula: The following formula is used to know the present value of aeries of expected income
throughout the life span of the capital assets. Sp = (R1 /1+r) + (R2 /1+r2 ) + ............ = (Rn /1+rn )
Here:

Sp = Stands for supply price of the new capital asset.

R 1 + R2 - R n = Stands for returns received on yearly basis.

R = The rate of discount applied each year.

If an entrepreneur does not invest his own savings but has to borrow from others, then it becomes
much clear that the expected rate of profit from investment in any capital asset must not be less
than the rate of profitable; the expected rate of profit must not be less than the current market rate
of interest (Chand, 2018). If the expected rate of profit is greater than the market interest he has to
pay. For instance, if an entrepreneur borrows funds from others at 15% rate of interest, then the
investment proposed to be undertaken will actually be undertaken only if the expected rate of profit
from it is more than 15 per cent. We thus see that investment depends upon marginal efficiency of
capital on the one hand and the rate of interest on the other.
Investment will be undertaken in any given form of capital asset so long as expected rate
of profit or marginal efficiency of capital falls to the level of the current market rate of interest.
The equilibrium of the entrepreneur is established at the level of investment where expected rate
of profit or marginal efficiency of capital is equal to the current rate of interest.
The equilibrium level of investment will be established at the point where margina l
efficiency of capital becomes equal to the given current rate of interest (McKenna & Zannoni,
1990). The curve of marginal efficiency of capital in general shows the demand for investment or
inducement to invest at various rates of interest (McKenna & Zannoni, 1990). Hence margina l
efficiency of the capital curve represents the investment demand curve. This investment demand
curve shows how much investment will be undertaken by the entrepreneurs at various rates of
interest. If the investment demand curve is less elastic, then investment demand will not increase
much with the fall in the rate of interest. But if the investment demand curve or marginal efficie nc y
of capital curve is very much elastic, then the changes in the rate of interest will bring about large
changes in investment demand.
The marginal efficiency of capital depends upon the supply price of capital on the one hand
and prospective yields on the other. The occurrence of depression is mainly due to the pessimis tic
expectations of the entrepreneurial class regarding profit making. On the contrary, when the
expectations of the entrepreneurs regarding profit opportunities increase, their inducement to
invest rises. As a result of the increase in investment, aggregate demand in the economy increases
and levels of income and employment increase.
7. Investment
Investment consists of the additions to the nation's productive physical capital such as machiner y,
buildings, software, and on change to inventories (Krugman & Wells, 2009).

Types of Investments
1. Business Fixed Investment
2. Residential Investment
3. Inventory Investment
4. Autonomous Investment
5. Induced Investment
• Business Fixed Investment
Business fixed investment means investment in the machines, tools and equipment that
businessmen buy for use in further production of goods and services. Business fixed investment is
important in two respects.

• Residential Investment
Residential investment refers to the expenditure which people make on constructing or
buying new houses or dwelling apartments for the purpose of living or renting out to others.
Residential investment depends on the price of existing housing units. The higher the price of
existing units, the higher will be investment in constructing and buying new housing units.

• Inventory Investment
Firms hold inventories of raw materials, semi-finished goods to be processed into final
goods. The firms also hold inventories of finished goods to be sold shortly. The change in the
inventories or stocks of these goods with the firms is called inventory investment. The first motive
of holding inventories is smoothing the level of production.

• Autonomous Investment
The investment which does not change with the changes in the income level and is therefore
independent of income is known as autonomous investment. Autonomous investment generally
takes place in houses, roads, public undertakings and in other types of economic infrastruc ture
such as power, transport and communication. This autonomous investment depends more on
population growth and technical progress than on the level of income. Most of the investme nt
undertaken by the Government is of the autonomous nature.

• Induced Investment
Induced investment is that investment which is affected by the changes in the level of income.
The greater the level of income, the larger will be the consumption of the community. In order to
produce more consumer goods, more investment has to be made in capital goods so that greater
output of consumer goods becomes possible. The essence of induced investment is that greater
income and therefore greater aggregate demand affects the level of investment in the economy.
The induced investment underlines the concept of the principle of accelerator, which is highly
useful in explaining the occurrence of trade cycles.
 AEC-13M-2022
Soniya Bashyal
Residential Investment
Residential investment is a form of real estate investment that constitutes one of the world most
valuable assets due to its durability. Residential investment refers to the expenditure which people
make on constructing or buying new houses or dwelling apartments for the purpose of living or
renting out to others. Residential investment varies from 3 per cent to 5 per cent of GDP in various
countries. Two important features of residential investment are worth noting. First, since the
average life of a housing unit is of 40 to 50 years, the stock of existing housing units at a point of
time is very large as compared to the new residential investment in a year (i.e., flow of residentia l
investment). Second, there is well developed resale market for housing units so that people who
construct or own them can sell them in this secondary market.
Residential investment depends on price of existing housing units. The higher the price of existing
units, the higher will be investment in constructing and buying new housing units. The price of
housing units is determined by demand for housing units which slopes downward and the supply
of existing units which is a fixed quantity and its supply curve is therefore vertical straight line.
Long-term housing demand is determined by population growth and the formation of new
households. The increased demand for housing units will result from the higher rate of population
expansion. Greater demand for housing units has resulted from the trend toward two-person
households. Another key factor influencing house demand and, as a result, residential investme nt
is income. Because income fluctuates significantly over time, there is a strong cyclical pattern in
residential building investment. Finally, interest is a significant component in determining the
demand for housing units. The majority of residences, particularly in cities, are purchased by
taking out long-term bank loans of 20 to 25 years. The houses are usually mortgaged with banks
or other financial entities that provide the necessary financing.
Residential investment is a notably volatile component of real GDP. Real house price growth, net
migration inflows and the size of the existing housing stock are the significant drivers of residentia l
investment (Kohlscheen, Mehrotra, & Mihaljek, 2018). Interest rate increases affect residentia l
investment more than interest rate cuts, and interest rate changes have larger effects on residentia l
investment when its share in overall GDP is rising.
The main determinants of residential investment in advanced economies are real house prices,
nominal interest rates, demographic factors, and the state of housing supply. House prices seem to
play a prominent role by affecting the incentives to invest in housing construction. The effects of
interest rates on residential investment are twice as large during housing booms than during the
busts, and are clearly stronger when interest rates are rising than when they are falling. Drops in
residential investment consistently lead economic downturns. Prior to an economic downturn,
house prices, construction activity and construction employment all decline.
Inventory Investment
Inventory investment is a component of gross domestic product (GDP). What is produced in a
certain country is naturally also sold eventually, but some of the goods produced in a given year
may be sold in a later year rather than in the year they were produced. Conversely, some of the
goods sold in a given year might have been produced in an earlier year. The difference between
goods produced (production) and goods sold (sales) in a given year is called invento ry investme nt.
The concept can be applied to the economy as a whole or to an individual firm, however this
concept is generally applied in macroeconomics (economy as a whole). Unintended unsold stock
of goods increases inventory investment.
Intended and unintended inventory investment
A positive flow of intended inventory investment occurs when a firm expects that sales will be
high enough that the current level of inventories on hand may be insufficient perhaps because in
the presence of very short-term fluctuations in the timing of customer purchases, there is a risk of
temporarily being unable to supply the product when a customer demands it. To avoid that
prospect, the firm deliberately builds up its inventories that is, engages in positive intended
inventory investment by deliberately producing more than it expects to sell. Economists view this
positive intended inventory investment as a form of spending in effect, the firm is buying
inventories from itself. Conversely, if a firm decides that its current level of inventories is
unjustifiably high some of the inventories are taking up costly warehouse space while exceeding
what is needed to prevent stock-outs then it will engage in a negative flow of intended inventor y
investment. It does this by deliberately producing less than what it expects to sell. Positive or
negative unintended inventory investment occurs when customers buy a different amount of the
firm's product than the firm expected during a particular time period. If customers buy less than
expected, inventories unexpectedly build up and unintended inventory investment turns out to have
been positive. If customers buy more than expected, inventories unexpectedly decline and
unintended inventory investment turns out to have been negative. Either positive or negative
intended inventory investment can coincide with either positive or negative unintended inventor y
investment. They are separate, unrelated events: one is based on deliberate actions to adjust the
stock of inventories, while the other results from mispredictions of customer demand.
Relationship to macroeconomic equilibrium
In macroeconomics, equilibrium in the goods market occurs when the supply of goods (output)
equals the demand for goods (the sum of various types of expenditure—consumer expenditure,
government expenditure on goods, net expenditures by people outside the country on the country's
exports, fixed investment expenditure on physical capital, and intended inventory investment). If
these are indeed equal for a particular time period, there is no unintended inventory investme nt
and there is goods market equilibrium. If they are not equal, there is disequilibrium in the goods
market. This is reflected in the presence of positive or negative unintended inventory investment.
Business fixed investment
Business fixed investment represents the spending by businesses to increase production capacity.
It is traditionally decomposed into equipment (such as computers and machines), structures (such
as plants, shopping malls, or warehouses), and intellectual property (such as software and R&D).
Business fixed investment means investment in the machines, tools and equipment that
businessmen buy for use in further production of goods and services. The stock of these machines
or plant equipment etc. represents fixed capital.
The term ‘fixed’ in it implies that expenditure made on the machines, equipment etc. continues to
be used for production for a relatively long time. This is in contrast to inventory investment whose
components will be either used shortly for production or sold shortly to others for further
production.
Business fixed investment is important in two respects. First, business fixed investment is an
important component of aggregate demand and therefore plays a significant role in the
determination of natural income and employment. Business fixed investment is a volatile
component of aggregate demand and, as Keynes emphasized, fluctuation in levels of fixed business
investment is responsible for business cycles in a free market economy.
Keynes put forward a theory of investment which states that business fixed investment is
determined by expected rate of profit (which he calls marginal efficiency of capital) and rate of
interest. Since rate of interest in the short run is relatively sticky, it is changes in expectations about
earning profits in future that cause fluctuations in business fixed investment.
According to the neoclassical theory, business fixed investment is determined by the margina l
product of capital on one hand and user’s cost of capital on the other. The user’s cost of capital
merely depends on the price of capital goods, the interest rate and the depreciation rate. According
to the neoclassical model, if marginal product of capital exceeds user’s cost of capital, firms will
find it profitable to undertake fixed investment.
Replacement cost of capital
Replacement cost of capital is a term referring to the amount of money a business must currently
spend to replace an essential asset like a real estate property, an investment security, a lien, or
another item, with one of the same or higher value. Sometimes referred to as a "replacement value,"
a replacement cost may fluctuate, depending on factors such as the market value of components
used to reconstruct or repurchase the asset and the expenses involved in preparing assets for use.
Insurance companies routinely use replacement costs to determine the value of an insured item.
Replacement costs are likewise ritually used by accountants, who rely on depreciation to expense
the cost of an asset over its useful life. The practice of calculating a replacement cost is known as
"replacement valuation." Companies utilize a procedure called net present value to determine
whether assets are in need of replacement and what the asset's value is. Companies first decide on
a discount rate, which is an estimate about a minimal rate of return on any corporate investme nt,
before making a choice on an expensive asset purchase. The cash outflow for the acquisition is
then weighed against the cash inflows created by the higher productivity of using a new and more
productive item. The cash inflows and outflows are adjusted to present value using the discount
rate, and the corporation makes the acquisition if the net total of all present values is positive.
Market value and replacement cost are both distinct concepts that are used to estimate the value of
a property. The market value is the price that a property will fetch in the open market between two
parties, i.e., the buyer and the seller, who are both knowledgeable about the dynamics of the real
estate market.
When estimating the market value of a property, parties include the value of the land and the value
of site improvements to the land, less the accrued depreciation. A property’s market value is
affected by several factors, such as location, crime rate, proximity to social amenities, etc.
On the other hand, replacement cost includes the estimated cost of constructing a building that is
similar to the building being evaluated at the current prices. The method considers the prices of
materials, labor, and special fees at the time of the valuation.
The replacement of the building uses current building designs and standards, as well as modern
methods, which may differ from the cost of the building being appraised. It excludes other costs,
such as demolition, debris removal, premiums for materials, site accessibility, etc.
Qualitative credit control measures
Also known as selective methods is used by the central bank to regulate the flows of credit into
particular directions of the economy. Unlike the quantitative methods, which affect the total
volume of credit, the qualitative methods affect the types of credit, extended by the commercia l
banks; they affect the composition rather than the size of credit in the economy. The important
tools of qualitative credit control measures are: (a) marginal requirements, (b) regulation of
consumer credit, (c) control through directives, (d) credit rationing, (e) moral suasion and
publicity, and (f) direct action.
Marginal requirements
Control over marginal requirements means control over down payments that must be made in
buying securities on credit. The marginal requirement is the difference between the market value
of the security and its maximum loan value. If a security has a market value of Rs.100 and if the
marginal requirement is 60% the maximum loan that can be advanced for the purchase of security
is Rs. 40. Similarly, a marginal requirement of 80% would allow borrowing of only 20% of the
price of the security and the marginal requirement of 100% means that the purchasers of securities
must pay the whole price in cash. Thus, an increase in the marginal requirements will reduce the
amount that can be borrowed for the purchase of a security.
Its advantages include:
• It controls credit in the speculative areas without affecting the availability of credit in the
productive sectors,
• It controls inflation by curtailing speculative activities on the one hand and by diverting
credit to the productive activities on the other,
• It reduces fluctuations in the market prices of securities,
• It is a simple method of credit control and can be easily administered. However, the
effectiveness of this method requires that there are no leakages of credit from productive
areas to the unproductive or speculative areas.
Regulation of Consumer Credit
This method was first used in US to regulate the terms and conditions under which the credit
repayable in installments could be extended to the consumers for purchasing the durable goods.
Under the consumer credit system, a certain percentage of the price of the durable goods is
paid by the consumer in cash. The balance is financed through the bank credit which is
repayable by the consumer in installments. The central bank can control the consumer credit-
(a) by changing the amount that can be borrowed for the purchase of the consumer durables
and (b) by changing the maximum period over which the installments can be extended.
Rationing of credit
Credit rationing is a selective method of controlling and regulating the purpose for which credit
is granted by the commercial banks. Rationing of credit may assume two forms- (a) the central
bank may fix its rediscounting facilities for any particular bank; (b) the central bank may fix
the minimum ratio regarding the capital of a commercial bank to its total assets.
Moral suasion Moral suasion means advising, requesting and persuading the commercial banks
to cooperate with the central bank in implementing its general monetary policy. Through this
method, the central bank merely uses its moral influence to make the commercial bank to
follow its policies. For instance, the central bank may request the commercial banks not to
grant loans for speculative purposes. Similarly, the central bank may persuade the commercia l
banks not to, approach it for financial accommodation. This method is a psychological method
and its effectiveness depends upon the immediate and favourable response from the
commercial banks.
Publicity
The central banks also use publicity as a method of credit control. Through publicity, the
central bank seeks- (a) to influence the credit policies of the commercial banks; (b) to educate
people regarding the economic and monetary condition of the country; and (c) to influence the
public opinion in favour of its monetary policy. The central banks regularly publish the
statement of their assets and liabilities; reviews of credit and business conditions; reports on
their own activities, money market and banking conditions; etc. From the published material
the banks and the general public can anticipate the future changes in the policies of the central
bank.
Direct method
The method of direct action is most extensively used by the central bank to enforce both
quantitative as well as qualitative credit controls. This method is not used in isolation; it is
often used to supplement other methods of credit control. Direct action refers to the directions
issued by the central bank to the commercial banks regarding their lending and investme nt
policies. Direct action may take different forms:
• The central bank may refuse to rediscount the bills of exchange of the commercia l
banks, whose credit policy is not in line with the general monetary policy of the central
bank,
• The central bank may charge a penal rate of interest, over and above the bank rate, on
the money demanded by the bank beyond the prescribed limit,
• The central bank may refuse to grant more credit to the banks whose borrowings are
found to be in excess of their capital and reserves.
Open Market Operations
Open market operations refer to central bank purchases or sales of government securities in order
to expand or contract money in the banking system and influence interest rates. It’s important to
understand that the Federal Reserve (Fed) can buy or sell securities, including governme nt
securities like Treasury bonds. These buy-and-sell transactions are the “operations.” The term
“open market” refers to the fact that the Fed doesn’t buy securities directly from the Treasury.
Instead, securities dealers compete on the open market based on price, submitting bids or offers to
the Trading Desk of Fed through an electronic auction system.
The use of open market operations as a monetary policy tool ultimately helps the Fed pursue its
dual mandate—maximizing employment, promoting stable prices—by influencing the supply of
reserves in the banking system, which leads to interest rate changes. Open market operations are
carried out by the central bank in association with the commercial banks. For conducting such
operations, there is no involvement of the public.
Government bonds are mostly bought by commercial banks, financial institutions, high net worth
individuals, and large business corporations. All these entities maintain accounts with the bank,
and whenever these entities purchase bonds, the amount gets transferred to the central bank.
Thus, it can be said that open market operations have an impact on the deposits and reserves of the
bank and also plays a role in their ability to provide credit. When a central bank wants to reduce
the availability of money to the public, it will sell government bonds and securities with the help
of commercial banks. This step reduces the money supply in the economy and restricts banks to
offer credit to individuals. It impacts both the supply and demand of the credit. Similarly, at times
when the liquidity conditions are tight, the central bank buys back the securities, which gives the
commercial banks and public easy access to the credit facilities that help in injecting liquidity into
the system and stabilizing the market.
Types of Open Market Operations
Permanent Open Market Operations
Permanent open market operations refer to the Fed's outright purchase or sale of securities for or
from its portfolio. Permanent OMOs are used to achieve traditional goals. For example, the Fed
will adjust its holdings to put downward pressure on longer-term interest rates and to improve
financial conditions for consumers and businesses. Permanent OMOs are also used to reinvest
principal received on currently held securities.
Temporary Open Market Operations
Temporary open market operations are used to add or drain reserves available to the banking
system on a short-term basis. They address reserve needs that are deemed to be transitory. Unlike
Permanent OMOs, which involve outright purchases or sales, Temporary OMOs are temporary
transactions. They're either repurchase agreements (repos) or reverse repurchase agreements
(reverse repos).
Quantitative credit control measures
Also known as general measures used by Central bank to control/ regulate the total volume of
credit in banking system, without any regard for the use to which it is put. Quantitative credit
control measures regulate the lending ability of the financial sector of the whole economy and do
not discriminate among the various sectors of the economy. The important quantitative methods
of credit control are:
Bank rate Policy
The bank rate policy is the traditional method of credit control used by a central bank. The bank
rate or the discount rate is the rate at which a central bank is prepared to discount the first-class
bills of exchange. Bank rate policy aims at influencing- (a) the cost and availability of credit to the
commercial banks, (b) interest rates and money supply in the economy, and (c) the level of
economic activity of the economy. A rise in the bank rate makes the credit costlier, reduces the
volume of credit, discourages economic activity and brings down the price level in the economy.
Similarly, a fall in the bank rate makes the credit cheaper, increases the volume of credit,
encourages the businessmen to borrow and invest, and increases the levels of economic activity
and the price level.
Open Market Operations
In view of the shortcomings of the bank rate policy, the development of open market operations -
the purchase and sale of government securities and other credit instruments in the open market-as
an additional and, to some extent, alternative instrument of central bank policy is a logical step.”
Open market operations refer to the deliberate and direct buying and selling of securities in the
money market by the central bank. In the narrow sense, open market operations refer to the
purchase and sale by the central bank of government securities in the money market. In the broad
sense, open market operations imply the purchase and sale by the central bank of any kind of
eligible paper, like, government securities, bills and securities of private concerns, etc.
Its objectives are:
• To influence the cash reserves with banking system
• To influence interest rates
• To stabilize the securities market by avoiding undue fluctuations in the prices and yields
of securities
Variables Cash Reserve Ratio
It is the most direct method because it controls the volume of credit by directly influencing the
cash reserves of the commercial banks. It produces immediate effect on the cash reserves of the
commercial banks. It is suitable when large changes in the cash reserves of the commercial banks
are required. It is not as flexible as the open market operations policy is. Since it is applicable to
the entire banking system, therefore, it cannot be varied in accordance with the requirements of
the local situation.
 AEC-14M-2022
Sandip Poudel

Balanced Growth
When production and the capital stock expand at the same rate, this is known as balanced growth.
The long-term stability of real interest rates may be explained by this development path, but it is
predicated on some significant assumptions (Temple, 2010). Balanced growth is the opposite of
volatile boom and busts economic cycles.
Benefits of balanced growth
1. Developing the balance zone:
This theory implies that all fields must be developed simultaneously. No industry has been
discriminated against in terms of development. If planning agencies decide to develop all sectors,
they will catch a wave of development that is almost balanced across regions. In fact, efficie nc y,
self-sufficiency and self-control are the result of the theory of balanced growth. In a sense,
balanced growth is the real savior of the LDCs problem.
2. Division of labor:
A wide range of markets will pave the way for a greater division of labor and specialization, which
will increase productivity and lead to improved product quality. Through the promotion of exports,
it contributes to foreign exchange earnings. A balanced growth strategy is one tool to encourage
that.
3. Specialization:
The balanced growth strategy helps to expand the market size. Expanding the market brings many
benefits. This leads to specialization, increasing efficiency through expertise. As a result, new
improvements are encouraged. Not only increased in quantity but also improved product quality.
Thus, balanced growth through specialization will contribute to improving both quantity and
quality of production. In the long run, international specialization depends on the size of the
market, according to Nurkse. It is through balanced growth that the size of the market can be
expanded through which productivity increases. It will also lead to increased productivity that all
countries can achieve.
4. Innovation and research opportunities:
This theory encourages innovations and researches in different fields of the economy. The
competition arises due to the simultaneous development of different industries. The industr ies
which are unable to produce qualitative products, cannot stand in competition with other
competitive industries and they automatically shut down their production.
With the result, only efficient and optimum firms remain in the market while others will exit the
market. In the modern scientific world, innovations and researches are very conducive for technical
progress as they lower the cost of production.
5. Creation of Social Overhead Capital:
Balanced growth is a tool for the creation of social overhead capital. When different industr ies
develop simultaneously, the investment it is made in other social overhead works as of
transportation, power jams, banking etc. This further encourages investment in human capital and
material capital, which is the fundamental principle of balanced growth.
6. Wide Extent of Market:
Generally, market imperfections and vicious circle of poverty obstruct the path of economic
development. This problem can be solved by adopting the principle of balanced growth. The
simultaneous development of different sectors helps in the production of variety of goods, which
in turn, would lead to the expansion of demand and enlargement of the market. Thus, it helps to
breech the vicious circle of poverty and market imperfections.
Balanced growth makes the possibility of better use of natural resources in a region. As it has been
observed that there are abundant natural resources in underdeveloped countries which remain
unutilized or under-utilized. Thus, balanced growth doctrine provides basic facilities for its better
use and allocation.
8. Less Dependence on Foreign Countries:
Most of the underdeveloped countries are dependent on foreign countries even for necessities of
life because they fail to adopt balanced strategy. The principle of balanced growth leads to enlarge
the extent of the market and external economies. It also helps to create social overheads. As a
result, there is less dependence on foreign countries.

9. Regional Balanced Growth:

Under balanced growth since different industries develop simultaneously, the chronic problems of
underdeveloped countries can be solved only by making investment in different sectors at the same
time. These countries can develop cottage and small-scale industries, large scale industries, means
of transport and communication, agriculture, trade etc. at one time. The plans can be formulated
to develop all the regions of the country by making investment in all the regions. This can be
possible only through balanced growth.
10. External Economies of Scale:
It is balanced growth which helps in generating external economies. These economies accrue
because of the increase in industries and expansion of market. In other words, external economies
are those which are received by new industries over the old industries. One industry has the
demand for products of other industries. For instance, if a cycle industry is set up, there is also
demand for iron and rubber. As iron and rubber industries were already is existence, so cycle -
industry can easily get iron and rubber.
These economies are of two types:
(a) Horizontal Economies:
These economies accrue when consumer goods industries are set up. With the setting up of some
consumer goods industries, setting up of other consumer goods industries is possible. The setting
up of different industries enlarge the size of the market. These economies are called horizonta l
economies.
(b) Vertical Economies:
These economies accrue when basic industries are set up at the first instance. These lead to
development of some less important industries automatically. These economies are called vertical
economies.
11. Encouragement of private enterprises:
Ragnar Nurkse, in his doctrine of balanced growth has stressed on the importance of private
investment. When investment is made in different sectors of the economy, there would be increase
in the importance of private entrepreneurs. He asserts, that the private entrepreneurs can contribute
considerably to economic development.
But from this, we should not conclude that the public investment has been ignored. In reality,
balanced growth can be materialized only if government directly participates in productive
activity. If the social overhead capital is spread over, then the remaining role should be played by
private entrepreneurs.
12. Breaking of Vicious Circle of Poverty:
Balanced Growth Theory has laid emphasis on simultaneous investment in both the sectors, i.e.,
agricultural and industrial. It leads to the development of both agriculture and industry.
Development of both the sectors brings- prosperity in the economy. Prosperity is responsible for
breaking of vicious circle of poverty. According to Nurkse, “If there is balanced growth of the
economy, it will help in breaking the vicious circle of poverty.”
13. Helpful in Getting over the Difficulty of Small Market:
The balanced growth theory is helpful in getting over the difficulty of small market in those
countries where mass poverty prevails. Such an approach suggests how, in any scheme of
development, a balanced growth can overcome the hurdle of the lack of market or demand.
According to Nurkse, “Balanced Growth Theory assists in increasing demand and supply and
widening of the market.”
14. Self-Reliance and Economic Stability:
The process of balanced growth involves a number of simultaneous activities, e.g., economic
planning, division of labour, specialization, productivity criteria of efficiency, increase in national
income and simultaneously increase in demand for goods and services, intersectoral balances,
interregional balances etc. Hence there is no scope for wide economic fluctuations. This process
implies a self-generating economy due to less dependence on foreigners. Thus, underdeveloped
countries depend on foreigners even for their basic necessities.
15. Better Utilization of Capital:
Balanced growth theory requires proper balance between investment in industry and agriculture.
As a result of it, economic development of a country is accelerated. It encourages savings which
turn into capital and thereby investment. In this way, it leads to better utilization of capital.
Price stability
Price stability is the condition when there is little to no change in the economy over a period of
time. This means that there is a lack of inflation or deflation occurring with prices. Price stability
suggests that prices are growing at a reasonable rate rather than not changing at all.
Price stability is a desirable circumstance, although being rare. By maximizing buying power, it
raises the standard of life and fosters economic freedom by maintaining stable employment levels.
Prices and economies that are stable lay the groundwork for a growing economy.
Some industries don't gain, even if stable employment and pricing levels are healthy for the
economy overall. Real estate and investments could not grow and value.
What makes price stability so crucial?
Being aware of the worth of your money is one of the most crucial elements of a healthy economy.
Extreme changes change the worth of money and make choosing products and prices challenging.
These variations can be classified as either inflation or deflation, when prices decline.
Negative effects of inflation
Individuals' purchasing power decreases as prices rise sharply. Consumers become more frugal as
a result. The consequent drop in demand has an effect on the price businesses may charge without
losing money.
Negative effects of deflation
Deflation may appear advantageous for businesses given that inflation is undesirable. This is not
true. When prices decrease sharply, buyers frequently decide to put off buying non-essential things
in the hope that costs will drop much more. Thus, deflation can also result in a decline in demand.
Price stability has the following advantages.
• This avoids the cost of inefficiency due to the presence of nominal rigidity.
• It reduces the inefficient cost of inflation, which is a tax on money balances.
• Avoids the negative effects of inflation on redistribution. The negative impact of infla tio n
on income and wealth varies by demographic group, with rising inflation being particular ly
detrimental to low-income households with limited investment options. Avoid adverse
interactions between inflation and taxation. The presence of inflation is distorting as taxes
are charged on a nominal basis and lack full indexing. For example, if nominal income
increases with inflation, but the tax rate does not update with inflation, you will end up
paying more tax even if your inflation-adjusted income does not change. increase. Keeping
inflation low and stable mitigates this impact.
• Reduce unexpected inflationary changes that lead to distortions. For example, when
inflation rises unexpectedly, savings fall in value, debt falls in value, and wealth shifts from
savers to borrowers.
• It reduces inflation volatility, lowers uncertainty and market interest rates, and increases
people's willingness to invest.
• Contribute to a more stable financial system.
 • It helps maintain social cohesion and stability. History shows that both episodes of high
inflation and episodes of deflation, or continued price declines, are associated with social
unrest. Stable inflation hits low-income households with fewer means to protect themselves
especially hard. When prices are stable, everyone wins:
• Price stability boosts economic growth and employment, and allows people to plan more
reliably when making decisions about borrowing, saving, and expanding their businesses.
How price stability is measured?
Price stability calculations vary by region. For example, the United States uses the Consumer
Price Index (CPI). Europe uses a similar indicator known as the Harmonized Consumer Price
Index (HICP). Both metrics involve complex formulas, but essentially, they look at a broad
cross-section of typical spending and measure how it has changed year-over-year. Ideally, the
variation is kept below 2%. Variation beyond this may indicate a problem.
Autonomous Investment
Autonomous investment is the portion of total investment made by a government or other entity
independent of economic considerations. An independent investment occurs when a governme nt
or other agency invests in a foreign country without considering the level of economic growth or
the prospect that the investment will generate a positive return. These investments are made
primarily for geopolitical stability, economic aid, infrastructure improvements, national or
personal security, or humanitarian purposes.
Autonomous investments are made because they are considered a basic need for the welfare, health
and safety of an individual, organization or nation, and are made even when the level of income is
available for zero or close to zero investment.
Stand-alone investments include inventory replenishment, public investment in infrastruc ture
projects such as roads and highways, and other investments that maintain or improve the economic
potential of the company. a country. They do not increase in response to higher gross domestic
product (GDP) growth or decrease as the economy shrinks, suggesting that they are not profit -
driven, but driven, for the purpose of improving the welfare of society.
Factors affecting autonomous investment:
Technically, independent investments are not affected by external factors. In reality, however,
several factors can influence them. For example, interest rates have a significant impact on
investments made in an economy. High interest rates can reduce consumption while low interest
rates can stimulate it. This, in turn, affects spending in an economy. Trade policies between
countries can also affect autonomous investments made by their citizens. If a producer of low-cost
goods imposes taxes on exports, this will have the effect of making finished goods destined for
external geographic areas more expensive.

The government can also impose controls on investments from an individual's own resources
through taxation. If a basic household item is taxed and there are no substitutes, the discretionar y
investment in that item may decreases.
 Figure 1. Autonomous investment
This autonomous investment depends more on population growth and technical progress
than on the level of income. The autonomous investment is not continuous in nature which means,
there could be a rise and fall in the amount of investments depending on the government’s desire.
Most of the investment undertaken by government of the autonomous nature. The autonomous
investment is depicted in figure 1. where it will be seen that whatever the level of national income,
investment remains the same at I.

Illustration of autonomous investment with a general linear investment equation is presented here:

I = a+bY
Where: I is investment expenditures, Y is income (or aggregate production), a is the intercept,
and b is the slope.
The two key parameters that characterize this investment equation are slope and intercept.
Autonomous investment is indicated by the intercept ‘a’ of the investment equation.
Induced Investment
The Induced Investment is a capital investment that is influenced by the shifts in the economy.
These investments are made with the intention to generate profit out of such investments. The
change in the cost of raw material, change in the tastes and preferences of customers, increase in
the lending or borrowing rates, etc., have a direct impact on the induced investments and to comply
with these shifts, a company put efforts to keep the investments viable.
Such investment is governed by the income and the amount of profit a firm can generate. Thus,
there is a direct relationship between the amount of investment and the income and profit earned
by the firm. If the income and profit tend to increase, the induced investment also increases and
vice-versa.
It is dependent on the level of income or on the rate of interest. Investment that would respond to
a change in national income or in the rate of interest is called induced investment. Fig. 3.10 shows
that, as national income rises from OY0 to 0Y1, (induced) investment increases from OI0 to OI1.
Thus, investment that is income-elastic is called induced investme nt.

That is,
I = f(Y)
The slope of the investment line II is the marginal propensity to invest (MPl). MPl is the ratio of
change in investment to the change in income. Or the ratio of increase in investment (A I) to an
increase in income (A Y) is called MPl, i.e.,
MPL = ∆l/∆Y
Keynes believed that interest rate and the expectation of future profitability of investment projects
are the two main determinants of investment expenditures in the short run. Investment is inversely
related to the level of interest rate, i.e., I = f(r).
However, Keynes emphasized more on the expected yield of investment project. But expectations
about the future profitability of investment are based on uncertain knowledge and, hence, such
expectations are full of uncertainties leading to instability in investment expenditure.
It is to be pointed out here that Keynes was primarily concerned with autonomous investment and
not with induced investment. However, in practice, it is very difficult to draw a line of demarcation
between these two types of investment.
Absolute Income Hypothesis
Keynes’ consumption function has come to be known as the ‘absolute income hypotheses or
theory. His statement of the relationship between income and consumption was based on the
‘fundamental psychological law’.
He said that consumption is a stable function of current income (to be more specific, current dis-
posable income—income after tax payment).
Because of the operation of the ‘psychological law’, his consumption function is such that 0 <
MPC < 1 and MPC < APC. Thus, a non- proportional relationship (i.e., APC > MPC) between
consumption and income exists in the Keynesian absolute income hypothesis. His consumptio n
function may be rewritten here with the form.
C = a + bY, where a > 0 and 0 < b < 1.
It may be added that all the characteristics of Keynes’ consumption function are based not on any
empirical observation, but on ‘fundamental psychological law’, i.e., experience and intuition.
Absolute income hypothesis is all about the basic relationship between consumption and
disposable income. Income that remains after paying all taxes, societal security charges available
to spend as own wish is disposable income.
Disposable income = total personal income – personal current taxes

Consumption Function
The consumption function, or Keynesian consumption function, is an economic formula that
represents the functional relationship between total consumption and gross national income. It was
introduced by British economist John Maynard Keynes, who argued the function could be used to
track and predict total aggregate consumption expenditures.
Consumption function represents the willingness of households to purchase goods and services at
a given level of income during a given time period.
Calculating consumption function
C = A + MD
Where, C = consumer spending
A = autonomous consumption
M = Marginal propensity to consume
D = real disposable income
The consumption function is assumed stable and static; all expenditures are passively determined
by the level of national income. The same is not true of savings, which Keynes called “investme nt, ”
not to be confused with government spending, another concept Keynes often defined as
investment.
For the model to be valid, the consumption function and independent investment must remain
constant long enough for national income to reach equilibrium. At equilibrium, business
expectations and consumer expectations match up. One potential problem is that the consumptio n
function cannot handle changes in the distribution of income and wealth. When these change, so
too might autonomous consumption and the marginal propensity to consume.

Fig 2. Keynes’s Consumption Function

The above graph shows a linear consumption function with an intercept term. In this form of linear
consumption function, though marginal propensity to consume (ΔC/ΔY) is constant, average
propensity to consume is declining with the increase in income as indicated by the slopes of the
lines OA and OB at levels of income Y1 and Y2 respectively. The straight- line OB drawn from
the origin indicating average propensity to consume at higher income level Y2 has a relatively less
slope than the straight- line OA drawn from the origin to point A at lower income level Y1. The
decline in average propensity to consume as the income increases implies that the proportion of
income that is saved increases with the increase in national income of the country.
This result also follows from the studies of family budgets of various families at different income
levels. The fraction of income spent on consumption by the rich families is lower than that of the
poor families. In other words, the rich families save a higher proportion of their income as
compared to the poor families. The assumption of diminishing average propensity to consume is a
significant part of Keynesian theory of income and employment. This implies that as income
increases, a progressively larger proportion of national income would be saved. Therefore, to
achieve and maintain equilibrium at full-employment level of income, increasing proportion of
national income is needed to be invested. If sufficient investment opportunities are not available,
the economy would then run into trouble and in that case, it would not be possible to maintain full
employment because aggregate demand will fall short of full-employment output. On the basis of
this increasing proportion of saving with the increase in income and consequently, the emergence
of the problem of demand deficiency, some Keynesian economists based the theory of secular
stagnation on the declining propensity to consume.

Marginal propensity to consume

In economics, marginal propensity to consume (MPC) is defined as the percentage of total wage
growth that consumers spend consuming goods and services rather than saving. The margina l
propensity to consume is part of Keynesian macroeconomic theory and is calculated as change in
consumption divided by change in income.
The MPC is represented by the consumption line, which is a slope line created by plotting changes
in consumption on the vertical "y" axis and changes in income on the horizontal "x" axis.
The marginal propensity to consume is equal to ΔC / ΔY, where ΔC is the change in consumptio n,
and ΔY is the change in income. If consumption increases by 80 rupees for each additiona l
hundreds of income, then MPC is equal to 80 / 100 = 0.8.

Marginal propensity to consume measures how much consumers will spend or save against an
overall increase in wages. In other words, if a person were to receive an increase in income, what
percentage of that new income would they spend? reflects a decline in In contrast, the lower the
income, the higher the marginal propensity to consume, since a higher proportion of the income
can be spent on daily living expenses.
 AEC-15M-2022
Samiksha Paudel
Average propensity to consume: The average propensity to income (APC) is the ratio of an
individual’s consumption and disposable income. It measures the percentage of income that is
spent rather than being saved by an entity. The entity may be an individual or a nation. This may
be calculated by a single individual who wants to know where the money is going or by an
economist who wants to track the spending and saving habits of an entire nation.

The portion of gross income left with an individual after they clear financial liabilities and taxation
is referred to as disposable income. Thus, it is the real income an individual can spend on
household needs, purchases, savings schemes, and investments.

Mathematically, it can be expressed as

Average propensity to consume (APC) =Consumption (C)/Total disposable income (DI)

APC is expressed as a percentage or decimal. In decimals, its value ranges between 0 and 1. At
zero (or 0%), all income is being saved and one (or 100%) indicates that all income is being
consumed. Higher average propensity to consume signals greater economic activity. When the
average propensity to consume is high, consumers are saving less and spending more on goods or
services. This increased demand drives economic growth, business expansion, and broad
employment.
Alternatively, lower average propensity signals a slowing economy as less goods are needed and
job stability is at risk.

Consider a household with a total consumption of $40,000 out of a total income of $70,000. An
individual’s propensity to consume is calculated as follows:
Average Propensity to Consume = $40,000 / $70,000 = 0.571

The average propensity concept highlights that demand and cash flow diminish if there is less
consumption. If the downtrend continues for longer, it could cause widespread bankruptcy,
liquidation, layoffs, and unemployment. Economists suggest low-income households have higher
APC; they are more likely to use their income to pay off debts and buy products against future
income and ultimately fall into debt trap.

Although the average propensity can explain the past consumption pattern of a household, finding
out how consumption is affected by any increase in income is determined using the margina l
propensity to consume. It makes the average marginal propensity to consume a comparative ly
more robust measure of consumption.

Marginal propensity to consume

Marginal propensity explains an increase in consumer expenditure with the increase in disposable
income (income after taxes and transfers). The proportion of disposable income spent by the
consumer is the marginal propensity to consume. MPC depends on the level of income. At higher
income MPC is lower.
The marginal propensity to consume is equal to ΔC / ΔY, where ΔC is the change in consumptio n,
and ΔY is the change in income. If consumption increases by 80 Rs. for each additional 100 Rs.
of income, then MPC is equal to 80/ 100 = 0.8.

Figure: Marginal propensity to consume

Mathematically, the MPC function is expressed as the derivative of the consumption function C
with respect to disposable income Y, i.e. the instantaneous slope of C-Y curve.
MPC = dC/dY.

Typically, the higher the income, the lower the MPC because as income increases more of a
person's wants and needs become satisfied; as a result, they save more instead. At low-income
levels, MPC tends to be much higher as most or all of the person's income must be devoted to
subsistence consumption.

According to Keynesian theory, an increase in investment or government spending increases

consumers’ income, and they will then spend more. If we know what their marginal propensity to
consume is, then we can calculate how much an increase in production will affect spending. This
additional spending will generate additional production, creating a continuous cycle via a process
known as the Keynesian multiplier. The multiplier effect is the proportional amount of increase or
decrease in final income that results from an injection or withdrawal of spending. The larger the
proportion of the additional income that gets devoted to spending rather than saving, the greater
the effect. The higher the MPC, the higher the multiplier—the more the increase in consumptio n
from the increase in investment; so, if economists can estimate the MPC, then they can use it to
estimate the total impact of a prospective increase in incomes. Thus, MPC act as an economic
stimulus.

Marginal propensity to import

The marginal propensity to import (MPM) is the amount of import increase or decrease with each
unit rise or decline in disposable income. The idea is that rising income for businesses and
households spurs greater demand for goods from abroad and vice-versa. Nations that consume
more imports as their population’s income increases have a significant impact on global trade.
Developed economies with sufficient natural resources within their borders typically have a lower
MPM than developing countries without these resources.
The level of negative impact on imports from falling income is greater when a country has a MPM
greater than its average propensity to import. This gap results in a higher income elasticity of
demand for imports, leading to a drop in income resulting in a more than proportional drop in
imports.
MPM is a component of Keynesian macroeconomic theory. The MPM is important to to study
Keynesian economics. First, the MPM reflects induced imports. Second, the MPM is the slope of
the imports line, which means it is the negative of the slope of the net exports line and makes it
important to the slope of the aggregate expenditures line, as well.
It is calculated as dIm/dy, meaning the derivative of the import function (Im) with respect to the
derivative of the income. The MPM indicated the extent to which imports are subject to change in
income or production. If, for example, a country’s MPM is 0.3, then each dollar of extra income
in that economy induces 30 cents of imports (Kenton, 2021).

Advantages and disadvantages of marginal propensity to import

MPM is easy to measure and functions as a useful tool to predict changes in imports based on
expected changes in output.
The problem is that a country’s MPM will unlikely remain consistently stable. The relative prices
of domestic and foreign goods change and exchange rates fluctuate. These factors impact
purchasing power for goods shipped in from overseas and, as a consequence, the size of a country’s
MPM.

Balance of payment
Balance of payments is the record of economic transactions of the residents of a country with the
rest of the world during a period. The aim to prepare such a record is to present an account of all
receipts on account of goods exported, services rendered and capital received by the residents of a
country and the payments made for goods imported, services received and capital transferred to
other countries by residents of a country (Ahuja, 2015). There may be deficit or surplus in balance
of payments. Both create problems for an economy. An important effect is that the transactions in
balance of payment are influenced by the exchange rate. The exchange rate is the rate at which a
country’s currency is exchanged for foreign currencies (Ahuja, 2015).
Balance of payment is also defined as a statement of all transaction made between in one country
and the rest of the world over a period of time which may be quarterly or a yearly. It is also known
as the balance of international payments which summarizes all the transactions that a country’s
individual, companies and government bodies complete with individuals, companies and
government bodies outside the country. These transactions consist of exports and imports of goods,
services and capital and also include transfer payments such as foreign aid and remittances.
Balance of payments divides the transaction into two accounts i.e., current account and capital
account. BoP must add up to current account and the capital financial account. However, the
exchange rate fluctuations and differences in accounting practices may hinder this in practice.
According to the World Bank, the US had the world’s largest current account deficit in 2019 with
$498 Billion. Trade deficit and surpluses exist in the balance of payments. When a country has
more export than its import, trade surplus exists and when a country exports less than it imports,
trade deficit will exist.
Balance of payments is more comprehensive in scope than balance of trade. It includes not only
imports and exports of goods which are visible items but also such invisible items as shipping,
banking, insurance, tourism, interest on investments, gifts, etc.
Nepal's Balance of Payments (BoP) recorded a deficit of Rs 15.15 billion in the first 11 months of
the current fiscal year (mid-July to mid-June) against a surplus of Rs 179.37 billion in the same
period of the previous year.
Balance of payments = Current account + Capital Financial account

Balance of trade
Balance of trade refers to the difference in value of imports and exports of commodities only, i.e.,
visible items only (Ahuja, 2015). Movement of goods between countries is known as visible trade
because the movement is open and can be verified by the customs officials. During a given period
of time, the exports and imports may be exactly equal, in which case, the balance of payments of
trade is said to be balanced. But this is not necessary, for those who export and import are not
necessarily the same persons. If the value of exports exceeds the value of imports, the country is
said to experience an export surplus or a favorable balance of trade. If the value of its imports
exceeds the value of its exports, the country is said to have a deficit or an adverse balance of trade
(Bernheim, 1988).
A flow of money spending on imports has been shown to be occurring from the domestic business
firms to the foreign countries (i.e., rest of the world). On the contrary, flow of money expenditure
on exports of a domestic economy has been shown to be taking place from foreign countries to the
business firms of the domestic economy. If exports are equal to the imports, then there exists a
balance of trade. Generally, exports and imports are not equal to each other. If value of exports
exceeds the value of imports, trade surplus occurs. On the other hand, if value of imports exceeds
value of exports of a country, trade deficit occurs. The difference between the value of a country’s
imports and exports for a given period is Balance of Trade. Balance of trade is also referred to as
the trade balance or the international trade balance. A country that exports more goods and services
than it imports in term of value has trade surplus. Conversely, a country that imports more goods
and services than it exports has a trade deficit.

Balance of Trade = Total value of export goods and services – Total value of import goods and
services
For an example, if a country imported $2 Billion in goods and services, but exported only $1 billio n
in goods and services, then the country had a trade balance of -$1Billion or a trade deficit of $1
Billion. In 2020, Nepal's trade deficit amounted to around 9.86 billion U.S. dollars. An economy
shows the following features:
Consumption, C = 50 + 0.9 (Y – T), Tax Revenue, T = 100, Investment, I = 150 – 5i Governme nt
expenditure, G = 100 Money demand, L = 0.2 y – 10i Real money supply =100 M P Exports, X =
20 Imports, M = 10 + 0.1 Y where Y = income, i = rate of interest figures in Rs. crores.

Balance of Trade (BOT) = X – M

X = 20
Imports, M = 10 × 0.1Y
As found above Y = 900 Imports (after calculation)
M = 10 + 0.1 × 900 = 10 + 90 = 100
BOT = 20 – 100 = – 80
Trade Deficit = 80

Terms of trade
Terms of trade (TOT) is a key economic metric of a company's health measured through what it
imports and exports. It is determined by dividing the price of the exports by the price of the imports
and multiplying the number by 100 and is expressed as a ratio that reflects the number of units of
exports that are needed to buy a single unit of imports. When more capital is leaving the country
than is entering the country then, the TOT will be less than 100%. When the TOT is greater than
100%, the country is accumulating more capital from exports than it is spending on imports.

Terms of trade for a country can be calculated by dividing its price index of exports by its price
index of imports. This ratio is then multiplied by 100:
TOT= (Pexports / Pimports)*100

Let us understand the concept in depth with a quick example. (All units costing 1 USD)

Country A: 1000 tons of corn, (needs 300), 800 tons of wheat (needs 1000)
Here, 700 surplus corn – 200 deficit wheat= 500 surplus remains

Country B: 100 tons of corn, (needs 700), 300 tons of wheat (needs 100)
Here, -600 deficit corn + 200 surplus wheat = – 400 deficit.

All prices being equal in our example, we see that the nation with a surplus stock is better suited
to meet its needs. In other words, there is a positive cash flow, and more capital is produced from
exports than imports.

A rise in the domestic currency's exchange rate should improve terms of trade, as this makes
imports relatively less expensive while boosting the prices of exports. Increasing the
competitiveness of firms will also tend to boost TOT as they can compete better internationa lly.
Inflation can also have a short-term benefit to TOT.

Export promotion
Trade promotion (sometimes referred to as export promotion) is an umbrella term for economic
policies, development interventions and private initiatives aimed at improving the trade
performance of an economic area. Such an economic area can include just one country, a region
within a country, or a group of countries involved in an economic trade area. Specific industr ies
may be targeted. Improvement is mainly sought by increasing exports both in absolute terms and
relative to imports.
When specific industries are targeted, trade promotion policies tend to target industries that have
a comparative advantage over their foreign competitors. Trade promotion can also include
expanding the supply of key inputs in a country's strongest industries, via import expansion. If
successful, such a tactic would lead to pro-trade biased growth.
Some international organizations provide assistance to so-called developing countries to help them
promote their exports, most prominently the International Trade Centre in Geneva, which is a
subsidiary of the World Trade Organization and the United Nations with a mandate to providing
trade-related technical assistance to those countries.
 AEC-16M-2022
Bhawana Aryal
Import substitution
Import substitution is a strategy under trade policy that abolishes the import of foreign products
and encourages production in the domestic market. The purpose of this policy is to change the
economic structure of the country by replacing foreign goods with domestic goods.
Import substitution is often "measured" by a change in the ratio of imports to the total availability
(imports plus domestic output) of a single product or category of products. If this ratio falls over
time, then import substitution is said to take place in that particular sector. This has happened, of
course, for many activities in many countries, and at the same time aggregate imports as a
proportion of total GDP have not declined and often have even risen. This means that the structure,
defined as the composition of output, of the economy is changing because some products that were
previously imported are no longer imported in the same amount, while total demand for imports
as a proportion of income is generally unchanged. The idea is that by replacing the imports of
certain commodities by domestic production, the economy will be so modified that it will begin to
be more independent, more resilient, more diversified, and better able to generate increasing
welfare as a matter of routine. Replacing the imports of certain individual products by their
domestic production is, therefore, a means to an end, not an end itself. Three additional points may
be noted.
(1) Many developing countries have levied tariffs, quotas, and other protective devices to meet
balance of payment difficulties. The objective in this situation is simply to curtail imports to bring
the balance of payments under control and is, therefore, sure to be different in effect from an import
substitution policy that is carefully and explicitly worked out. It will be argued later that one of the
important reasons why import substitution has often seemed to be the source of grave problems is
the fact that policy-making has so frequently been ad hoc, and that various parts of the set of
policies have been inconsistent with each other. The policy-making process in a particular country
is, therefore, relevant to understanding how and why countries pursue the policies that they do.
(2) The import substitution rationale is also distinct from the traditional infant industry argument
for the protection of a particular, activity. That argument rests on the assumption that an activity
can be identified which, if given some initial period of protection, will later become able to
compete in an unprotected market. In the case of import-substitution one might speak of an infant
economy that needs protection while it develops those characteristics it must have to produce rising
welfare.
(3) Import substitution should also be distinguished from "delinking". This latter notion examined
with great insight by Diaz-Alejandro (1973) refers to a permanent cutoff of a country in all or some
respects from the rest of the world in order for truly indigenous development to occur. Delink ing
does not represent a time during which the economy is restructured and reorganized in order for it
to take its place in the world economy.
Demonstration effect on consumption
Demonstration effect refers to the consumption habit of the people to imitate the consumptio n
trends adopted by other people. The demonstration effect increases propensity which reduces the
rate of savings and investment. A very important principle has been propounded regarding
consumption, viz.; that an individual’s consumption docs not merely depend on individual’s own
income bur it is very much influenced by the standard of living or consumption of his friends and
relations. When a man sees that some of his friends and relatives have refrigerate, scooter, radio
or TV set, good furniture, good clothes, etc. he likes to imitate them and is desirous of ‘possessing
and using these things. As soon as he can afford or when his income increases, he buys such things.
This means that instead of increasing his savings, when his income increases, he increasing
consumption.
Thus, consumption does not depend upon absolute real income but on relative level of real income.
That is, consumption expenditure does not depend on our own purchasing power but on what is
being spent by other on the purchase of luxury articles. An eminent American economist
Boysenberry has called it ‘Demonstration Effect.’ The demonstration effect has adversely affected
people’s capacity to save. It has been estimated that 75 per cent Americans are unable to make any
saving. It does not mean that they were too poor to save. But they cannot save because they Thus,
consumption does not depend upon absolute real income but on relative level of real income. That
is, consumption expenditure does not depend on our own purchasing power but on what is being
spent by other on the purchase of luxury articles. An eminent American economist Boysenberry
has called it ‘Demonstration Effect.’ The demonstration effect has adversely affected people’s
capacity to save. It has been estimated that 75 per cent Americans are unable to make any saving.
It does not mean that they are too poor to save. But they cannot save because they also export to
them their higher standard of living. Their superior standard of living increases their propensity to
consume. because they try to imitate their standard of living. Nurkse calls it Instructio na l
Demonstration Effect.’ He says When people come into contact with superior goods or superior
patterns of consumption, with new articles or new ways of meeting old wants. they are apt to feel
after a while certain restlessness and dissatisfaction. Their knowledge is extended, their
imagination is stimulated new desires are aroused the propensity to consume is shifted upward.
Propensity to consume directly affects propensity to save: Higher the consumption less is the
saving. When poor countries imitate the higher standards of living of the rich countries, they have
to pay the price for it. The price is that their capacity to save is reduced. As Nurkse observes: “The
great and growing gaps between the income levels and. therefore. Irving standards of differe nt
countries, combined with increasing awareness of these gaps, may tend to push up the general
propensity to consume of the poor nations. reduce their propensity to save. The decrease in their
propensity to save is bound to prove a big obstacle in the path of their economic development.
Temporary income
Temporary income means periodic income paid under a pension plan, an annuity or a LIF to a
person for a temporary period of time after retirement for the purposes of supplementing retirement
income until the person is eligible to receive benefits. You can withdraw an additional amount
from your LIF (Life Income Fund), called a "temporary income". However, your LIF contract
must offer the option of a temporary income and you must apply each year to your financ ia l
institution. When your financial institution receives your application for a temporary income, it
calculates the amount that you can withdraw (if you are entitled to do so) and has you complete
the required declarations. Even though payment of a temporary income reduces the life income
amount, the maximum income drawn from the LIF (temporary income plus adjusted life income)
may in fact be higher. A temporary income cannot be greater than 40% of the maximum
pensionable earnings for the year.
Interest
Interest is the monetary charge for the privilege of borrowing money. Interest expense or revenue
is often expressed as a dollar amount, while the interest rate used to calculate interest is typically
expressed as an annual percentage rate (APR). Interest is the amount of money a lender or financ ia l
institution receives for lending out money. Interest can also refer to the amount of ownership a
stockholder has in a company, usually expressed as a percentage.
Interest is the concept of compensating one party for incurring risk and sacrificing the opportunity
to use funds while penalizing another party for the use of someone else's funds. The person
temporarily parting ways with their money is entitled to compensation, and the person temporarily
using those funds is often required to pay this compensation.
When you leave money in your savings account, your account is credited interest. This is because
the bank uses your money and loans it out to other clients, resulting in you earning interest revenue.
The amount of interest a person must pay is often tied to their creditworthiness, the length of the
loan, or the nature of the loan. All else being equal, interest and interest rates are higher when there
is greater risk; as the lender faces a greater risk in the borrower not being able to make their
payments, the lender may charge more interest to incentivize them to make the loan.
In its most basic form, interest is calculated by multiplying the outstanding principal by the interest
rate.
Interest = Interest Rate * Principal or Balance
The more complex aspect in calculating interest is often determining the correct interest rate. The
interest rate is often expressed as a percentage and is usually designated as the APR. However, the
APR often does not reflect any effects of compounding. Instead, the effective annual rate is used
to express the actual rate of interest to be paid.
Often, an annual rate must be converted to calculate the applicable interest earned in a given period.
For example, if a savings account is to pay 3% interest on the average balance, the account may
award 0.25% (3% / 12 months) each month.
The applicable interest rate is then multiplied against the outstanding amount of money related to
the interest assessment. For loans, this is the outstanding principal balance. For savings, this is
often the average balance of savings for a given period.
Simple vs. Compound interest
Two main types of interest can be applied to loans—simple and compound. Simple interest is a set
rate on the principal originally lent to the borrower that the borrower has to pay for the ability to
use the money. Compound interest is interest on both the principal and the compounding interest
paid on that loan. The latter of the two types of interest is the most common.
For obvious reasons, individuals attempting to earn interest prefer compound interest agreements.
This agreement results in interest being earned on interest and results in more total earnings.
Savings accounts with banks often earn compound interest; any prior interest earned on your
savings is deposited into your account, and this new balance is what earns interest in future periods.
On the other hand, compound interest is extremely concerning for borrowers especially if their
accrued compound interest is capitalized into their outstanding principal. This means the
borrower's monthly payment will actually increase due to now having a greater loan than what
they started with.
IS
The IS curve shows combinations of interest rates and levels of output such that planned spending
equals income. ‘OR’ The IS Curve represents various combinations of interest and income along
which the goods market is in equilibrium.

Figure: IS cure
Logical Reasoning for IS Curve to Slope Downwards:
The IS curve is negatively sloped because a decrease in the interest rate (i) increases planned
investment spending (I) and therefore increases aggregate demand, thus increasing the equilibr ium
level of income.
LM
In macroeconomics terms, LM refers to the liquidity of money. As interest rates increase, the
demand for money decreases. LM is really part of a larger model, the IS-LM model, where IS-LM
stands for Investment Saving - Liquidity Preference Money Supply. These large words are
basically just used to model money and income in an economy.

The models are used to define points of equilibrium, or balance; in other words, intersecting values
where the demanded money equals the amount available to invest. While the formulas are a little
more complex, it boils down to the basic economic analysis of supply versus demand.
LM Equation
The LM equation calculates the demand for money, and the equation is represented here:
L=k*Y- h*I
L = Demand for Real Money
k = Income Sensitivity of Demand for Real Money
Y = Income
h = Interest Sensitivity of Demand for Real Money
i = Interest Rate
When we talk about real money, we aren't comparing real cash to Monopoly money. Instead, real
money is adjusted for inflation. This tells us the true purchasing ability of money, or in essence,
what your money can get you. The demand for money also depends on income. The more you
make, the more you spend, or save in offshore accounts. It also depends on the interest rate, since
people also leverage their money through investing.
We're subtracting the interest rate. As interest rates rise, people tend to invest their money.
The variables k (income sensitivity) and h (interest sensitivity) are modifiers that are added to
income and the interest rates and will have value greater than zero. When talking about sensitivity
in this case, we're talking about the likelihood of change.
Derivation of the LM Curve:
The LM curve can be derived from the Keynesian theory from its analysis of money market
equilibrium.

According to Keynes, demand for money to hold depends upon transactions motive and
speculative motive. It is the money held for transactions motive which is a function of income.
The greater the level of income, the greater the amount of money held for transactions motive and
therefore higher the level of money demand curve.
The demand for money depends on the level of income because they have to finance their
expenditure, that is, their transactions of buying goods and services. The demand for money also
depends on the rate of interest which is the cost of holding money. This is because by holding
money rather than lending it and buying other financial assets, one has to forgo interest.
Thus, demand for money (Md) can be expressed as:
Md = L(Y, r)
where Md stands for demand for money, Y for real income and r for rate of interest. Thus, we can
draw a family of money demand curves at various levels of income. Now, the intersection of these
various money demand curves corresponding to different income levels with the supply curve of
money fixed by the monetary authority would give us the LM curve.
The LM curve relates the level of income with the rate of interest which is determined by money-
market equilibrium corresponding to different levels of demand for money. The LM curve tells
what the various rates of interest will be (given the quantity of money and the family of demand
curves for money) at different levels of income.

But the money demand curve or what Keynes calls the liquidity preference curve alone rises. In
Fig. 20.2 (b) we measure income on the X-axis and plot the income level corresponding to the
various interest rates determined at those income levels through money market equilibrium by the
equality of demand for and the supply of money in Fig. 20.2 (a).

Slope of LM Curve:
It will be noticed from Fig. 20.2 (b) that the LM curve slopes upward to the right. This is because
with higher levels of income, demand curve for money (Md) is higher and consequently the
money- market equilibrium, that is, the equality of the given money supply with money demand
curve occurs at a higher rate of interest. This implies that rate of interest varies directly with
income. It is important to know the factors on which the slope of the LM curve depends. There are
two factors on which the slope of the LM curve depends. First, the responsiveness of demand for
money (i.e., liquidity preference) to the changes in income. As the income increases, say from Y0
to Y1, the demand curve for money shifts from Md0 to Md1, that is, with an increase in income,
demand for money would increase for being held for transactions motive, Md or L1 =f(Y).
This extra demand for money would disturb the money market equilibrium and for the equilibr ium
to be restored the rate of interest will rise to the level where the given money supply curve
intersects the new demand curve corresponding to the higher income level. It is worth noting that
in the new equilibrium position, with the given stock of money supply, money held under the
transactions motive will increase whereas the money held for speculative motive will decline.

The greater the extent to which demand for money for transactions motive increases with the
increase in income, the greater the decline in the supply of money available for speculative motive
and, given the demand for money for speculative motive, the higher the rise in the rate of interest
and consequently the steeper the LM curve, r = f (M2, L2) where r is the rate of interest, M2 is the
stock of money available for speculative motive and L2 is the money demand or liquid ity
preference function for speculative motive.
The second factor which determines the slope of the LM curve is the elasticity or responsive ness
of demand for money (i.e., liquidity preference for speculative motive) to the changes in rate of
interest. The lower the elasticity of liquidity preference for speculative motive with respect to the
changes in the rate of interest, the steeper will be the LM curve. On the other hand, if the elasticity
of liquidity preference (money demand function) to the changes in the rate of interest is high, the
LM curve will be flatter or less steep.
 ABM-02M-2022
Namrata Giri
General Equilibrium
General Equilibrium Theory is a macroeconomic theory that explains how supply and demand in
an economy with many markets interact dynamically and eventually culminate in an equilibr ium
of prices. It shows how supply and demand in a multi- market economy interact and create an
equilibrium of prices. The theory assumes that there is a gap between actual prices and equilibr ium
prices. The goal of the theory is to identify the precise set of circumstances under which the
equilibrium price is likely to achieve stability.
The key characteristic of general equilibrium models is that they are economy-wide – constraints
apply at both the individual and the system level. It is used extensively in many branches of
economics, most notably in macroeconomics and in international trade theory.
Importance of general equilibrium
• A change in an economic system generally have repercussions far beyond the sector in
which the change occurs. General equilibrium models are designed to help us understand
those repercussions.
• It helps to address the policy issues in the area of tax reform. It focused on measures of
efficiency and distributional impact of tax reform proposal, or of trade liberaliza tio n
policies.
• It is also used for multi-sector planning.

Computable general equilibrium (CGE)

This models attempt to take the general equilibrium theory and turn it into a practical tool for
policy analysis. They do so by building computer models of real economic systems using some
software, fitting the models to real data on the economic structure of those systems, and simula ting
the effects of policy changes inside the models. CGE models are used widely in international trade,
public finance, regional economics, and environmental economics.
Advantage of CGE
• High degree of theoretical consistency.
• Have the ability to highlight the importance of linkages between sectors.
• Capable of incorporating unique features of an economic system.
• Can be used to predict values for many economic variables in the system.
Limitation of CGE
• The data requirements of CGE models are substantial.
• The human capital investment required in building/using these models is very high
. • There is often uncertainty over parameters, specification, and experimental design.
• By covering all sectors in an economy, a CGE model may miss key features of critical sectors.
• It is of complex nature and the simulation results are often unpredictable and the various
interdependence and feedback among the variables make it difficult to predict in advance what the
result of simulation will look like.

Shoe Leather Cost

Shoe-Leather Costs refer to the time and effort people take to minimize the effect of inflation on
the eroding purchasing power of money. People wear out their shoes on the way back and forth to
the bank, so to speak, trying to protect the value of their assets. It suggests that people spend their
time and resources to manage their money and other financial assets, i.e. inflation- hed ging
activities, rather than using those resources to produce goods and services.
Shoe-Leather Costs and Interest Rates
Shoe-leather costs of inflation is related to the interest rate's role in money demand. When infla tio n
and expectations of inflation is rises, so does the nominal interest rate. The nominal interest rate is
composed of the real interest rate and the rate of expected inflation. As a result of the rise in
nominal interest rates, individuals hold less cash in order to keep more of their money in interest
bearing accounts. Holding less cash requires more trips to the bank thus, shoe-leather costs of
inflation increase.
Some Examples
The costs of inflation are readily apparent during extreme episodes of inflation, known as
hyperinflation. The most famous episode of hyperinflation occurred in Germany in the 1920s when
prices increased 100 times from mid-1922 through mid-1923. By November 1923, the price level
was more than one billion times its level in August 1922. Economists use the term "distortio nar y
effects" to describe the impact of such a condition on the economy.
Anecdotes of the distortionary effects of the German hyperinflation include stories that workers
were paid two to three times per day, rushing out to spend their pay before their money became
worthless. Under these conditions, the banking system expanded and took on crucial importance —
especially for those with the resources to beat the devastating effects of inflation by holding foreign
currency and precious metals. The number of persons employed by German banks rose from about
100,000 in 1913 to 375,000 in 1923.
While the costs of hyperinflation are enormous and obvious, the smaller costs associated with more
mild inflation are more subtle and more difficult to measure. Inflation of 10 percent, for example,
results in a misallocation of resources (shoe-leather costs) that amounts to somewhere between 1
and 2 percent of GDP. Costs of an inflation rate of 3 percent are about half a percent of GDP—
approximately $40 billion. In addition, an increase in expected inflation leads people to economize
on the money they hold as cash in order to keep it working in financial investments, in some cases
taking extremely high risks in the hope of returns on investment that exceed the inflation rate. It is
this cost of minimizing money holdings that gives rise to shoe-leather costs. Therefore, one way
to measure the costs is to estimate the effects of a given rise in inflation on the demand for money.
Demand Pull Inflation
Inflation is a general rise in the price of goods in an economy. When consumer demand outpaces
the available supply of many types of consumer goods, demand-pull inflation sets in, forcing an
overall increase in the cost of living. It describes the effects of an imbalance in aggregate
supply and demand. When the aggregate demand in an economy strongly outweighs the aggregate
supply, prices go up. This is the most common cause of inflation.
In Keynesian economic theory, an increase in employment leads to an increase in aggregate
demand for consumer goods. In response to the demand, companies hire more people so that they
can increase their output. The more people firms hire, the more employment increases. Eventua l ly,
the demand for consumer goods outpaces the ability of manufacturers to supply them.
Causes of Demand-Pull Inflation
There are five primary causes of demand pull inflation:

1. A growing economy: When consumers feel confident, they spend more and take on more
debt. This leads to a steady increase in demand, which means higher prices.
2. Increasing export demand: A sudden rise in exports forces an undervaluation of the
currencies involved.
3. Government spending: When the government spends more freely, prices go up.
4. Inflation expectations: Companies may increase their prices in expectation of inflation in
the near future.
5. More money in the system: An expansion of the money supply with too few goods to buy
makes prices increase.

For example: Assuming the economy is in a boom period, and the unemployment rate falls to a
new low. Interest rates are at a low point, too. The federal government, seeking to get more gas-
guzzling cars off the road, initiates a special tax credit for buyers of fuel-efficient cars. The big
auto companies are thrilled, although they didn't anticipate such a confluence of upbeat factors all
at once.
Demand for many models of cars goes through the roof, but the manufacturers literally can't make
them fast enough. The prices of the most popular models rise, and bargains are rare. The result is
an increase in the average price of a new car.
It's not just cars that are affected, though. With almost everyone gainfully employed and borrowing
rates at a low, consumer spending on many goods increases beyond the available supply. That's
demand-pull inflation in action
Thus, Demand-pull inflation explains rising prices in an economy as the result of increased
aggregate demand that surpasses supply. As consumers demand more given limited supply, prices
are bid higher. Demand-pull inflation can be contrasted with cost-push inflation, whereby higher
costs of production are passed on to consumers.
Cost Push Inflation
Inflation is the decline of purchasing power of a given currency over time. Inflation is sometimes
classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
Aggregate supply is the total volume of goods and services produced by an economy at a given
price level. When the aggregate supply of goods and services decreases because of an increase in
production costs, it results in cost-push inflation. It is a result of the increase in prices working
through the production process inputs such as raw materials and labor. Higher costs of production
can decrease the aggregate supply (the amount of total production) in the economy. Since the
demand for goods hasn't changed, the price increases from production are passed onto consumers
creating cost-push inflation. For example: if companies use copper in the manufacturing process
and the price of the metal suddenly rises, companies might pass those increase on to their
customers that leads to increase in consumer price and decrease in purchasing power of the
consumers.
Causes of Cost-Push Inflation:
• High wage rate
• High profit margin
• Government regulation or taxation
• Scarcity of raw materials
• Monopoly
• Unexpected causes like natural disasters; floods, landslides, earthquakes, etc.
For cost-push inflation to occur, demand for goods must be static or inelastic; where the demand
cannot be easily adjusted according to rising prices. One example of cost-push inflation is the oil
crisis of the 1970s. The price of oil was increased by OPEC countries, while demand for the
commodity remained the same. As the price continued to rise, the costs of finished goods also
increased, resulting in inflation (Oner, 2021).
Demand Pull Inflation Vs Cost Push Inflation
Cost-push inflation occurs when money is transferred from one economic sector to another.
Specifically, an increase in production costs such as raw materials and wages inevitably is passed
on to consumers in the form of higher prices for finished goods.
Demand-pull and cost push inflation move in practically the same way but they work on differe nt
aspects of the system. Demand-pull inflation demonstrates the causes of price increases. Cost-push
inflation shows how inflation, once it begins, is difficult to stop.
Monetarist Inflation
Monetarists argue that if the money supply rises faster than the rate of growth of national income,
then there will be inflation (Pettinger, 2017). If the money supply increases in line with real output
then there will be no inflation. M.Friedman stated that “Inflation is always and everywhere a
monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in
the quantity of money than in output.”
Quantity theory of money
Fischer version MV=PT ;where, M = Money supply, P = Price level and
V = Velocity of circulation, T= Transactions

Transactions is difficult to measure so it is often substituted for Y = National income,

MV = PY where Y= national output
The above equation must hold the value of expenditure on goods and services must equal the value
of output.
Why money supply leads to inflation??
Monetarist believe that in the short-term velocity (V) is fixed. This is because the rate at which
money circulated is determined by institutional factor, e.g. how often workers are paid does not
change very much. Milton Friedman admitted it might vary a little but not very much so it can be
treated as fixed. Monetarists also believe output Y is fixed. They state it may vary in the short run
but not in the long run (because LRAS is inelastic and determined by supply-side factors.)
According to monetarists inflation is purely monetary phenomenon that can only be produced by
expanding the money supply at a faster rate than the growth of capacity output.
Thus at any given time the actual rate of inflation is seen as reflecting current and past rates of
monetary expansion. Monetarists reject nonmonetary explanations of inflation (Humphrey, n.d.)
Budget Deficit
A budget deficit is a phenomenon of expenses exceeding revenue,often applied to governme nt
budgets. It occurs when expenses exceed revenue and can indicate the financial health of a country.
It is commonly used to refer to government spending rather than business or individuals. Budget
deficits affect the national debt, the sum of annual budget deficits, and the cumulative total a
country owes to creditors.
When a budget deficit is identified, current expenses exceed the amount of income received
through standard operations. To correct its nation's budget deficit, often referred to as a fiscal
deficit, a government may cut back on certain expenditures or increase revenue-genera ting
activities.
A budget deficit can lead to higher levels of borrowing, higher interest payments, and low
reinvestment, which will result in lower revenue during the following year. Talking about Nepal
its budget deficit is increased from 1705 million in year 2019 to 1811million in 2020.
Cause of Budget Deficit
Both levels of taxation and spending affect a government's budget deficit. Common scenarios that
create deficits by reducing revenue and increasing spending include:
• Tax structure that under taxes high-wage earners but overtaxes low-wage earners.
• Increased spending on programs like Social Security, Medicare, or military spending.
• Increased government subsidies to targeted industries.
• Tax cuts that decrease revenue but provide corporations with funds to increase employment.
• Low GDP, or gross domestic product, results in lower tax revenue.
Budget deficits may occur as a way to respond to certain unanticipated events and policies.
Effects of a Budget Deficit
Budget deficits affect individuals, businesses, and the overall economy. As the government takes
steps to improve the deficit, spending for programs such as Medicare or Social Security may be
curtailed. Improvements to infrastructure may also be affected .To increase government revenue,
tax hikes may occur for high-income earners or large corporations which may affect their ability
to invest in new business ventures or hire new employees.
A looming concern of a budget deficit is inflation, which is the continuous increase of price levels.
In the United States, a budget deficit can cause the Federal Reserve to release more money into
the economy, which feeds inflation and continued budget deficits can lead to inflationary monetary
policies, year after year.
Strategies to Reduce Budget Deficits
Countries counter budget deficits by promoting economic growth through fiscal policies, such
as reducing government spending and increasing taxes. Determining the best strategies regarding
which spending to cut or whose taxes to raise are often widely debated.
To pay for government programs while operating under a deficit, the federal government borrows
money by selling U.S. Treasury bonds, bills, and other securities. This strategy carries the risk of
devaluing the nation’s currency, which can lead to hyperinflation.
Reduced regulations and lower corporate income taxes improve business confidence, stimulate
further employment, and promote economic growth leading to higher taxable profits and an
increase in income tax revenue.

Deficit Financing
Deficit financing in advanced countries is used to mean an excess of expenditure over revenue, the
gap being covered by borrowing from the public by the sale of bonds and by creating new money.
The term ‘deficit financing’ is used to denote the direct addition to gross national expenditure
through budget deficits, whether the deficits are on revenue or on capital account.
The essence of such policy lies in government spending in excess of the revenue it receives. The
government may cover this deficit either by running down its accumulated balances or by
borrowing from the banking system (mainly from the central bank of the country).
Causes/ Purpose of Deficit Financing
There are various purposes of deficit financing. To finance war-cost during the Second World War,
massive deficit financing was made. Being a war expenditure, it was construed as an unproductive
expenditure during 1939-45. However, Keynesian economists do not like to use deficit financ ing
to meet defense expenditures during the war period. It can be used for developmental purposes
too.
Developing countries aim at achieving higher economic growth. A higher economic growth
requires finances. But the private sector is shy of making huge expenditures. Therefore, the
responsibility of drawing financial resources to finance economic development rests on the
government. Taxes are one of such instruments of raising resources.
If the usual sources of finance are inadequate for meeting public expenditure, a government may
resort to deficit financing.
• To finance defense expenditures during war
• To lift the economy out of depression so that incomes, employment, investment, etc., all rise
• To activate idle resources as well as divert resources from unproductive sectors to productive
sectors with the objective of increasing national income and, hence, higher economic growth
• To raise capital formation by mobilizing forced savings made through deficit financing
• To mobilize resources to finance massive plan expenditure
Effects of Deficit Financing
Deficit financing has several economic effects which are interrelated in many ways:
• Deficit financing and inflation
It is said that deficit financing is inherently inflationary. Since deficit financing raises aggregate
expenditure and, hence, increases aggregate demand, the danger of inflation looms large. This is
particularly true when deficit financing is made for the persecution of war.
Whether deficit financing is inflationary or not depends on the nature of deficit financing. Being
unproductive in character, war expenditure made through deficit financing is definite ly
inflationary. But if a developmental expenditure is made, deficit financing may not be inflatio nar y
although it results in an increase in money supply. Deficit financing, undertaken for the purpose
of building up useful capital during a short period of time, is likely to improve productivity and
ultimately increase the elasticity of supply curves. And the increase in productivity can act as an
antidote against price inflation. In other words, inflation arising out of inflation is temporary in
nature. The end result of deficit financing is inflation and economic instability. Though painless,
it is very much inflation-prone compared to other sources of financing.
• Deficit financing and capital formation and economic development
Economic development largely depends on capital formation. The basic source of capital
formation is savings. But, LDCs are characterized by low saving- income ratio. In these low-saving
countries, deficit finance- led inflation becomes an important source of capital accumulatio n.
During inflation, producers are largely benefited compared to the poor fixed-income earners.
Saving propensities of the former are considerably higher. As a result, aggregate savings of the
community becomes larger which can be used for capital formation to accelerate the level of
economic development. Further, deficit-led inflation tends to reduce consumption propensities of
the public. Such is called ‘forced savings’ which can be utilized for the production of capital goods.
Consequently, a rapid economic development will take place in these countries. National income
does not rise enough due to deficit financing since these countries suffer from shortage of capital
equipment and other complementary resources, lack of technical knowledge and entrepreneurs hip,
lack of communications, market imperfections, etc.
• Deficit financing and income distribution
It is said that deficit financing tends to widen income inequality. This is because of the fact that it
creates excess purchasing power. But due to inelasticity in the supply of essential goods, excess
purchasing power of the general public acts as an incentive to price rise. During inflation, it is said
that the rich become richer and the poor become poorer. Thus, social injustice becomes prominent.
However, all types of deficit expenditure do not necessarily tend to disturb existing social justice.
If money collected through deficit financing is spent on public goods or in public welfare
programs, some sort of favourable distribution of income and wealth may be made. Ultimate ly,
excess dose of deficit financing leading to inflationary rise in prices will exacerbate income
inequality. Anyway, much depends on the volume of deficit financing.
Advantages of Deficit Financing
The easiest and the most popular method of financing is the technique of deficit financing. That is
why it is the most popular method of financing in developing countries.
1. Massive expansion in governmental activities has forced governments to mobilize resources
from different sources. As a source of finance, tax-revenue is highly inelastic in the poor countries.
Above all, governments in these countries are rather hesitant to impose newer taxes for the fear of
losing popularity. Similarly, public borrowing is also insufficient to meet the expenses of the state.
As deficit financing does not impinge any trouble either to the taxpayers or to the lenders who lend
their surplus money to the government, this technique is most popular to meet developmenta l
expenditure. Deficit financing does not take away any money from anyone’s pocket and yet
provides massive resources.
2. Financial resources (required for financing economic plans) that a government can mobilize
through deficit financing are certain and known beforehand. The financial strength of the
government is determinable if deficit financing is made. As a result, the government finds this
measure handy.
3. Deficit financing has certain multiplier effects on the economy. This method encourages the
government to utilize unemployed and underemployed resources. This results in more incomes
and employment in the economy.
4. Deficit financing is an inflationary method of financing. However, the rise in prices must be a
short run phenomenon. Above all, a mild dose of inflation is necessary for economic development.
Thus, if inflation is kept within a reasonable level, deficit financing will promote economic
development —thereby neutralizing the disadvantages of price rise.
5. During inflation, private investors go on investing more and more with the hope of earning
additional profits. Seeing more profits, producers would be encouraged to reinvest their savings
and accumulated profits. Such investment leads to an increase in income—thereby setting the
process of economic development rolling.
Disadvantages of Deficit Financing
It is a self-defeating method of financing as it always leads to inflationary rise in prices. Unless
inflation is controlled, the benefits of deficit- induced inflation would not fructify. And,
underdeveloped countries— being inflation-sensitive countries—get exposed to the dangers of
inflation.
1. Deficit financing- led inflation helps producing classes and businessmen to flourish. But fixed -
income earners suffer during inflation. This widens the distance between the two classes. In other
words, income inequality increases.
2. Another important drawback of deficit financing is that it distorts investment pattern. Higher
profit motive induces investors to invest their resources in quick profityielding industries. Of
course, investment in such industries is not desirable in the interest of a country’s economic
development.
3. Deficit financing may not yield good results in the creation of employment opportunities.
Creation of additional employment is usually hampered in backward countries due to lack of raw
materials and machinery even if adequate finance is available.
4. As purchasing power of money declines consequent upon inflationary price rise, a country
experiences flight of capital abroad for safe return thereby leading to a scarcity of capital.
5. This inflationary method of financing leads to a larger volume of deficit in a country’s balance
of payments. Following inflationary rise in prices, export declines while import bill rises, and
resources get transferred from export industries to import-competing industries.
 ABM-03M-2022
Karishma Subedi
Public debt
Government makes the yearly budget in order to conduct the development activities in the country.
For this government requires sources to finance the budget, which is obtained through differe nt
sources like tax and non-tax revenue. The problem is that revenue solely is deficit in providing the
financial support to the budget. Thus, public debt comes handy. It is an instrument to finance the
deficit resources. Public debt is the total amount, including total liabilities, borrowed by the
government to meet its development budget. It usually refers to national debt. Public debt allows
governments to raise funds to grow their economies or pay for services.
• Condition when public debt is good: In the short run, public debt is a good way for countries
to get extra funds to invest in their economic growth. When used correctly, public debt can
improve the standard of living in a country. It allows the government to build new roads
and bridges, improve education and job training, and provide pensions. This encourages
people to spend more now instead of saving for retirement. This spending further boosts
economic growth.
• Condition when public debt is bad: Politicians generally prefers to increase public debt
than raising taxes as it makes them popular with voters. Investors usually don't become
concerned until the debt-to-GDP ratio reaches a critical level. The World Bank has said the
tipping point is 77% or more.

Floating debt
Floating debt is a short term debt that is continually refinanced, renewed, or rolled over to meet
the ongoing operational requirements by the issuer. It is meant that mass of lawful and valid claims
against the corporation for the payment of which there is no money in the corporate treasury
specifically designed, nor any taxation nor other means of providing money to pay particular ly
provided. The main advantage of floating debt is a chance to benefit from reductions in interest
rates. Moreover, the interest rates on long term debt are usually higher than interest rates on short
term debt. Therefore, the company may save money by refinancing short term debt. However, the
demerit of this process is that the company may incur loss, if interest rates rise and they have to
refinance at a higher cost. The percentage of fixed or floating rate debt varies from firm to firm. A
firm can have different strategies when choosing the floating debt. It can have 100% of floating
rate debt or zero floating rate debt, or a mix of fixed and floating rate debt. When total debt issuance
leans more towards one type of debt, this might signal the company’s view on interest rates. The
market timing theory stipulates that debt management decisions are governed by a speculative
motive with the focus on lowering the expected cost of debt servicing. According to the market
timing view, firms borrow floating rate debt when the perceived cost of borrowing floating rate
debt is lower than the fixed rate debt and vice versa. Thus when yield spread (that is, the differe nce
between the long and short term borrowing rate) is higher, firms are more likely to borrow floating
rate debt. Floating rate funds can include preferred stock, corporate bonds, and loans that have
maturities from one month to five years. Floating rate funds can include corporate loans and
mortgages as well. Floating rate loans are loans made by banks to companies. A floating interest
rate, also known as a variable or adjustable rate, refers to any type of debt instrument, such as a
loan, bond, mortgage, or credit, that does not have a fixed rate of interest over the life of the
instrument.

Sunk debt
Sunk cost or sunk debt refers to money that has already been spent and cannot be recovered. A
manufacturing firm, for example, may have a number of sunk costs, such as the cost of machiner y,
equipment, and the lease expense on the factory. Sunk costs are excluded from a sell or-process-
further decision, which is a concept that applies to products that can be sold as they are or can be
processed further. The sunk cost are usually the fixed costs. All sunk cost is fixed cost but all fixed
cost is not sunk cost. The difference is that sunk cost cannot be recovered. Sunk cost is not only in
business but can occur in normal people life. For example, if you buy aeroplane tickets and cannot
reach at last minutes then the cost to buy ticket is sunk cost. Sunk costs are excluded from future
business decisions because the cost will remain the same regardless of the outcome of a decision.
If a sunk cost can be eliminated at some point, it becomes a relevant cost and should be a part of
business decisions about future events. A sunk cost (also known as retrospective cost) is a cost that
has already been incurred and cannot be recovered. Sunk costs are contrasted with prospective
costs, which are future costs that may be avoided if action is taken. In other words, a sunk cost is
a sum paid in the past that is no longer relevant to decisions about the future.

Long Term Debt

Long Term Debt (LTD) is any amount of outstanding debt a company holds that has a maturity of
12 months or longer. It is classified as a non-current liability on the company’s balance sheet. The
time to maturity for LTD can range anywhere from 12 months to 30+ years and the types of debt
can include bonds, mortgages, bank loans, debentures, etc. Long-term debt is debt that matures in
more than one year and is often treated differently from short-term debt. For an issuer, long- term
debt is a liability that must be repaid while owners of debt (e.g., bonds) account for them as assets.
Long-term debt liabilities are a key component of business solvency ratios, which are analyzed by
stakeholders and rating agencies when assessing solvency risk. Entities choose to issue long- term
debt with various considerations, primarily focusing on the timeframe for repayment and interest
to be paid. Investors invest in long-term debt for the benefits of interest payments and consider the
time to maturity a liquidity risk. Overall, the lifetime obligations and valuations of long-term debt
will be heavily dependent on market rate changes and whether or not a long-term debt issuance
has fixed or floating rate interest terms. A company takes on debt to obtain immediate capital.
For example, startup ventures require substantial funds to get off the ground. This debt can take
the form of promissory notes and serve to pay for startup costs such as payroll, development, IP
legal fees, equipment, and marketing.

Long Term Debt on the Balance Sheet: Long Term Debt is classified as a non-current liability on
the balance sheet, which simply means it is due in more than 12 months’ time. The LTD account
may be consolidated into one line-item and include several different types of debt, or it may be
broken out into separate items, depending on the company’s financial reporting and accounting
policies.

Types of Long Term Debt: Long term debt is a catch-all phrase that includes various differe nt
types of loans. Below are some examples of the most common different types of long term debt:
Bank Debt – This is any loan issued by a bank or other financial institution and is not tradable or
transferable the way bonds are.

Mortgages – These are loans that are backed by a specific piece of real estate, such as land and
buildings.

Bonds – These are publicly tradable securities issued by a corporation with a maturity of longer
than a year. There are various types of bonds, such as convertible, callable, zero-coupon,
investment grade, high yield (junk), etc.

Debentures – These are loans that are not backed by a specific asset and, thus, rank lower than
other types of debt in terms of their priority for repayment.

Short term debt

Short term debt, also called current liabilities, is a firm’s financial obligations that are expected to
be paid off within a year. Short term debt is defined as debt obligations that are due to be paid
either within the next 12 months’ period or the current fiscal year of a business. They can be seen
in the liabilities portion of a company’s balance sheet. Short term debt is separated from long term
debt, which consists of debt obligations a company has whose repayment period extends more than
12 months into the future. The most common measure of short term liquidity is the quick ratio
which is integral in determining a company’s credit rating that ultimately affects that company’s
ability to procure financing.
Quick ratio = (current assets- inventory)/ current liabilities. The value of short term debt account
is very important when determining a company’s performance. Simply put, the higher the debt to
equity ratio, the greater the concern about company liquidity. If the account is larger than the
company’s cash and cash equivalents, this suggests that the company may be in poor financ ia l
health and does not have enough cash to pay off its impending obligations.
Types of debt: The debt obligations of a company are commonly divided into 2 categories: •
Financing debt
• Operating debt

Financing debt: It refers to debt obligations that arise from company borrowing money to fund the
expansion of its business. An example of financing debt may be taking out a large bank loan or
issuing bonds to fund a major capital expenditure, such as the construction of a new plant .
Financing debt is typically long term debt since the amount of debt incurred is usually too large
for a company to be able to repay within one year. Short term debt more commonly consists of
operating debt, incurred during a company’s ordinary business operations. Examples of short-term
debt
Short term debt may exist in several different forms. Some most common examples of short term
debt include:
• Account payable: It includes all the money a company owes through ordinary credit purchases
from suppliers, such as purchases from wholesalers to stock its products. It also includes monthly
bills, such as utility bills and office rent.
 • Short- term loans: A company often take out a short- term loan from a bank or other lending
institution to help it bridge a cash flow problem. If a company is having trouble collecting its
accounts receivable, that can make it difficult to cover its accounts payable.

• Commercial paper: Instead of taking out a bank loan, some companies choose to issue
commercial paper unsecured promissory notes that typically come due in nine months or less.

• Lease payments: It’s common for many companies to lease, rather than purchase. The payments
on such leases that are due within the next 12 months are a component of the company’s short term
debt.

• Taxes due: The tax component of short term debt includes any local, state, federal, or other types
of taxes that a company may owe that are due to be paid within the current year.

• Salary and wages: All salaries due to be paid to employees within the current year are also
considered part of short term debt.

• Stock Dividends: If a company has declared, but not yet paid, stock dividends to its shareholders,
the dividends are part of the company’s short term debt. Assessing a Company’s Debt Financia l
analysts typically use several financial metrics to examine a company’s debt liability to determine
how financially sound the company is. Two commonly used ratios that focus on a company’s short
term debt obligations are:
• Current ratio: It is calculated as the company’s current assets divided by its current liabilities. i.e.
Current ratio = Current assets/ current liabilities A current ratio of 1 indicates that the company’s
liquid assets roughly match its current liabilities.
A ratio higher than 1 indicates that its current assets are more than sufficient to meet its current
debt obligations.

• Working capital ratio: It is the sum of current assets minus current liabilities that a company
holds excess capital beyond that which is required to pay off its short term debt.

Internal Debt
Internal debt is that part of the total debt that is owed to lenders within the country. It is the money
the government borrows from its own citizens. Public debt or internal debt is undoubtedly caused
by excessive expenses, which may be caused by the militarization of the economy, extensive
administration or high social transfers. The main reason for the public deficit is the failure to adjust
the size of public expenditure to the profitability of the economy. Major forms of public debt are:
1. Internal and External Debt
2. Productive and Unproductive Debt
3. Compulsory and Voluntary Debt
4. Redeemable and Irredeemable Debts
5. Short-term, Medium-term and Long-term loans
6. Funded and Unfunded Debt
External debt
According to the International Monetary Fund, "Gross external debt is the amount, at any given
time, of disbursed and outstanding contractual liabilities of residents of a country to non-residents
to repay principal, with or without interest, or to pay interest, with or without principal. In public
finance, external debt (or foreign debt) is the component of the total government debt which is
owed to foreign creditors. The debt includes money owed to private commercial banks, foreign
governments, or international financial institutions such as the International Monetary Fund (IMF)
and World Bank.
If a country cannot repay its external debt, it faces a debt crisis and said to be in sovereign default.
The International Monetary Fund (IMF) is one of the agencies that keeps track of countries'
external debt. The World Bank publishes a quarterly report on external debt statistics.
External debt, particularly tied loans, might be set for specific purposes that are defined by the
borrower and lender. Such financial aid could be used to address humanitarian or disaster needs.
For example, if a nation faces severe famine and cannot secure emergency food through its own
resources, it might use external debt to procure food from the nation providing the tied loan. If a
country needs to build up its energy infrastructure, it might leverage external debt as part of an
agreement to buy resources, such as the materials to construct power plants in underserved areas.
 ABM-04M-2022
Pawan Kumar Chaudhary

Monetary Burden of Debt:

Debt burden is the cost of servicing debt. The debt burden is defined as the ratio of interest
payments on the publicly held debt to national income. For consumers, it is the cost of interest
payments on debt. The debt burden will be higher for credit cards and loans with high interest. The
debt burden on mortgages will be relatively lower compared to the value of the loan. For countries,
the debt burden is the cost of servicing the public debt. Most of this debt burden is a really transfer
from one generation to another. However, National debt can be a real debt burden because:
• If the debt is held externally. E.g. 25% of US debt is held abroad making the US liable
for external interest transfers.
• When debt is held externally, it may also cause a depreciation in the exchange rate and
hence a worsening of the terms of trade. (imports more expensive)
Interest charges on debt that arise as a result of borrowing by individuals, firms and governme nts
is burden of debt. In the case of governments, interest charges on the national debt are paid for out
of taxation and other receipts. The term ‘burden’ would seem to imply that government borrowing
is a ‘bad’ thing insofar as it passes on financial obligations from present (overspending)
generations to future generations. The fundamental point to emphasize, however, is that the interest
paid on the national debt is a transfer payment and does not represent a net reduction in the capacity
of the economy to provide goods and services, provided that most of this debt is owed to domestic
citizens. High public debt may also cause higher taxes which distort work incentives etc.
Debt burden ratios: This is the ratio of debt burden to income. For example, if you pay £2,000 in
debt interest and have an income of £40,000. Your debt burden ratio is 5%. If you a country has a
debt burden of £100bn and pays debt interest of £60bn. Its debt burden is 60%. Sometimes the
debt burden is measured as GDP / Total debt

Real Burden of Debt:

Real burden means total burden including money burden.it is necessary to raise taxation to pay
interest on the debt and, the greater the debt, greater the amount of taxation required to provide the
interest on it. Ordinarily, taxpayers are poor people. When the government pays interest with
principal to the bondholders, it results in the transfer of purchasing power from the poor people to
the richer people. Thus, the payment of internal debt involves redistribution of aggregate income.
This results in inequalities in the distribution of income and wealth. This is the direct real burden
of debt on the community. Indirect real burden of external borrowing is crucial. Usually,
government imposes taxes to finance external debt. But taxes have disincentive effects. It
discourages work- effort and saving. Lower the saving, lower is the capital formation. Thus,
external borrowing eats away economic growth since growth largely depends on capital formatio n.
This indirect real burden of external debt is quite similar to internal debt. The conventional wisdom
holds that public debt, like private debt, places a significant burden on the community. According
to the classical approach, if government expenditures are funded through taxation, the current
generation bears the brunt of the burden. However, if government spending is funded by public
borrowing, the current generation is relieved of the load, and the responsibility is moved to future
generations. Future generations suffer as a result of the current generation’s reduced savings in
order to meet debt financing obligations, leaving a smaller pool of capital resources for the future.
This will limit the future generation’s productive ability, and they will suffer as a result. In certain
ways, war financing via public debt has a two-fold effect. To contribute to war funding, for
example, the current generation must either reduce their consumption or save more money, or both.

Growth
In economics, economic growth means an increase in real GDP which means an increase in the
value of national output/national expenditure. It is the process to economic development and is an
important macroeconomic objective as it enables increased living standards, improved tax
revenues and helps to create better employment in the short term, economic growth is caused by
an increase in aggregate demand. If there is spare capacity in the economy, then an increase in
Aggregate demand (AD) will cause a higher level of real GDP.
AD= C+I+G+X-M
• C= Consumer spending
• I = Investment (gross fixed capital investment)
• G = Government spending
• X = Exports
• M = Imports
Long term economic growth requires an increase in the long run aggregate supply (productive
capacity) as well as aggregate demand.
Other factors affecting economic growth
1. Economic and political stability
2. Low inflation
Policymakers who want to encourage growth in living standards must aim to increase their nation’s
productive ability by encouraging rapid accumulation of the factors of production and ensuring
that these factors are employed as effectively as possible. Economists differ in their views of the
role of government in promoting economic growth. At the very least, government can lend support
to the invisible hand by maintaining property rights and political stability. More controversial is
whether government should target and subsidize specific industries that might be especially
important for technological progress. There is no doubt that these issues are among the most
important in economics. The success of one generation’s policymakers in learning and heeding the
fundamental lessons about economic growth determines what kind of world the next generation
will inherit.
Population growth has a variety of effects on economic growth. On the one hand, more rapid
population growth may lower productivity by stretching the supply of natural resources and by
reducing the amount of capital available for each worker. On the other hand, a larger population
may enhance the rate of technological progress because there are more scientists and engineers.
Figure 1: GDP growth rate of Nepal in different years.
Source: FAO, 2022

Productivity:
The quantity of goods and services produced from each unit of labor input is known as
productivity. Productivity is commonly defined as a ratio between the output volume and the
volume of inputs. It assesses how effectively production inputs like labor and capital are utilized
in an economy to achieve a certain level of output. Productivity’s key role in determining living
standards is as true for nations as it is for stranded sailors. The uses of productivity are given
below:
• Productivity is regarded as a fundamental source of economic growth and competitiveness,
and as such, it serves as the foundation for many international comparisons and
assessments of country performance.
• Productivity data, for example, is used to look into the impact of product and labor market
laws on economic performance.
• Productivity growth is an important factor to consider when calculating an economy's
productive potential.
• It also enables analysts to calculate capacity utilization, which helps them to assess the
state of economies in the business cycle and estimate economic growth
• Production capacity is also used to estimate demand and inflationary pressures.
Measurement of Productivity
Determinants of productivity:
1. Physical capital: The stock of equipment and structures that are used to produce goods
and services
2. Human capital: The knowledge and skills that workers acquire through education,
training, and experiences
3. Natural resources: The inputs into the production of goods and services that are provided
by nature, such as land, rivers, and mineral deposits
4. Technological knowledge: Society’s understanding of the best ways to produce goods and
services
There are many types of productivity measures. Broadly productivity measure is classified
into: Single -factor productivity measures (relating a measure of output to a single measure of
input) or multifactor productivity measures (relating a measure of output to a bundle of inputs).
Productivity measure depends on the purpose of productivity and data availability. The table
below shows some measures of productivity.

Types of Types of input measure

output
measure
Labor Capital Capital and
Capital, labor and
labor intermediate inputs
(energy, materia ls,
services)
Gross Labor Capital Capital-labor KLEMS multifacto r
output productivity productivity MFP (based productivity
(based on gross (based on gross on gross
output) output output)
Value Labor Capital Capital -labor -
added productivity productivity MFP (based
(based on value (based on value on value
added) added) added)
Single factor productivity Multi factor productivity

Development:
Development refers to a process of gradual transformation. Economic Development is the increase
in the level of production in an economy along enrichment of living standards and the advancement
of technology. In the context of a growing economy, economic development refers to the reduction
and elimination of poverty, unemployment, and inequality. It refers to the processes and strategies
that a country uses to better its citizens' social, economic, and political well-being and is concerned
with resource allocation. Economic progress is associated with an increase in human capital
indexes and a reduction in inequality. It is concerned with the effects on people.
Following are the indicators of development: -
 • Human Development Index (HDI)
• Human Poverty Index (HPI)
• Gini Coefficient
• Gender Development Index (GDI)
• Balance of trade
• Physical Quality of Life Index (PQLI)
• Per capita income index
• Basic need approach
Economic growth vs. Economic Development: - Although the term growth and development are
used as synonyms, there are some differences between them. Economic growth refers to rise
overtime in a country’s real national income or national product. Economic development implies
more than this, it implies progressive and fundamental changes in the socio-economic structure of
a country’s economy. The development implies growth as well as change in the structure of
economy.

Technology:
Technology is the application of scientific knowledge to the practical aims of human life or, as it
is sometimes phrased, to the change and manipulation of the human environment. The branch of
knowledge that deals with the creation and use of technical means and their interrelation with life,
society, and the environment, drawing upon such subjects as industrial arts, engineering, applied
science, and pure science. The various types of technology are given below with examples:
• Materials Technology: Applications: Piezoelectric materials used in micro-thrusters for
satellites, self-healing coatings used to protect metal products.
• Mechanical Technology: Applications: Cars manufactured by using mechanical robots,
3D printers, Power plants
• Medical Technology Applications: Stethoscope, pacemakers, ventilators, computed
tomography (CT) scanners, surgical robots
• Electronics Technology Applications : Computers, smartphones, digital camera, RADAR
(Radio Detection and Ranging), power suppliers, mustimeters, interactive Sensors
• Communication Technology Applications : LAN (Local area network), videotext,
teletext, Internet, wireless information transfer, GPS
• Nuclear Technology Applications : Production of electrical energy, radiotherapy, smoke
detectors, sterilization of disposable products, Radioisotope Thermal Generators used in
space missions
• Biotechnology Applications: Use of microorganisms for creating organic products like
milk and baking bread, extraction of metals from their ores through the use of living
organisms (bioleaching), production of biological weapons
• Information Technology Applications: Multimedia conferencing, e-commerce, cloud
computing, online banking, speech recognition, Intrusion Detection System, online
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Labor:
Labor is the second factor of production. The physical and mental efforts of human beings who
participate in the production process are referred to as labor. Unskilled, semi-skilled, and highly
skilled labor are all included. Changes in labor supply are influenced by price changes. It rises in
tandem with salary growth. Wages and salaries are the financial compensation for labor.
Labor means any valuable service rendered by a human agent in the production of wealth, other
than accumulating and providing capital or assuming the risks that are a normal part of business
undertakings. It includes the services of manual laborers, but it covers many other kinds of services
as well. It is not synonymous with toil or exertion, and it has only a remote relation to “work done ”
in the physical or physiological senses. The application of the physical energies of people to the
work of production is, of course, an element in labor, but skill and self-direction, within a larger
or smaller sphere, are also elements.
If labor could be measured adequately in simple homogeneous units of time, such as labor-hours,
the problems of economics would be considerably simplified. But laborers differ in the amount
and character of their training, in their degree of skill, intelligence, and capacity to direct their own
work or the work of others, and in the other special aptitudes that they require.

Bibliography
(n.d.). Retrieved from https://www.britannica.com/topic/labor-in-economics
(n.d.). Retrieved from https://www.economicsdiscussion.net/debt-2/burden-of-public-debt-and-
its-measurement/17464
(n.d.). Retrieved from https://www.investopedia.com/terms/d/development-economics.asp
(n.d.). Retrieved from https://corporatefinanceinstitute.com/resources/economics/economic-
growth/
Mankiw, N. G. (n.d.). principles of macroeconomics.
Snowdon, B., & Vane, H. R. (n.d.). Modern Macroeconomics.
 ABM-05M-2022
Leela Chaudhary
CAPITAL
Capital is a broad term that can describe anything that confers value or benefit to its owners, such
as a factory and its machinery, intellectual property like patents, or the financial assets of a business
or an individual.
While money itself may be construed as capital, capital is more often associated with cash that is
being put to work for productive or investment purposes. In general, capital is a critical component
of running a business from day to day and financing its future growth.
Business capital may derive from the operations of the business or be raised from debt or equity
financing. Common sources of capital include:

• Personal savings
• Friends and family
• Angel investors
• Venture capitalists (VC)
• Corporations
• Federal, state, or local governments
• Private loans
• Work or business operations
• Going public with an IPO

When budgeting, businesses of all kinds typically focus on three types of capital: working capital,
equity capital, and debt capital. A business in the financial industry identifies trading capital as a
fourth component.
Types of Capital
Below are the top four types of capital that businesses focus on in more detail
Debt Capital
A business can acquire capital by borrowing. This is debt capital, and it can be obtained through
private or government sources. For established companies, this most often means borrowing from
banks and other financial institutions or issuing bonds. For small businesses starting on a
shoestring, sources of capital may include friends and family, online lenders, credit card
companies, and federal loan programs.
Like individuals, businesses must have an active credit history to obtain debt capital. Debt capital
requires regular repayment with interest. The interest rates vary depending on the type of capital
obtained and the borrower’s credit history.
Issuing bonds is a favorite way for corporations to raise debt capital, especially when prevailing
interest rates are low, making it cheaper to borrow. In 2020, for example, corporate bond issuance
by U.S. companies soared 70% year over year, according to Moody's Analytics. Average corporate
bond yields had then hit a multi-year low of about 2.3%.
Equity Capital
Equity capital can come in several forms. Typically, distinctions are made between private equity,
public equity, and real estate equity.
Private and public equity will usually be structured in the form of shares of stock in the company.
The only distinction here is that public equity is raised by listing the company's shares on a stock
exchange while private equity is raised among a closed group of investors.
When an individual investor buys shares of stock, they are providing equity capital to a company.
The biggest splashes in the world of raising equity capital come, of course, when a company
launches an initial public offering (IPO). In 2021, the Duolingo IPO valued the company at $5
million and shook the Nasdaq market.
Working Capital
A company's working capital is its liquid capital assets available for fulfilling daily obligations. It
is calculated through the following two assessments:

• Current Assets – Current Liabilities

• Accounts Receivable + Inventory – Accounts Payable

Working capital measures a company's short-term liquidity. More specifically, it represents its
ability to cover its debts, accounts payable, and other obligations that are due within one year.
Note that working capital is defined as current assets minus its current liabilities. A company that
has more liabilities than assets could soon run short of working capital.
Trading Capital
Any business needs a substantial amount of capital to operate and create profitable returns. Balance
sheet analysis is central to the review and assessment of business capital.
Trading capital is a term used by brokerages and other financial institutions that place a large
number of trades daily. Trading capital is the amount of money allotted to an individual or a firm
to buy and sell various securities.

BOOM
Before diving into what boom actually means, it is quite important to understand the trade cycle
(business cycle). Business cycle refers to the cyclical fluctuations in an economy brought about by
fluctuations in economic factors such as employment, profits, prices, income, etc. the variatio ns
thus produced are wave like in structure, composed of alternate phases of upswings or prosperity
and downswings or adversity. The fluctuations are due to changes in free markets or some
unpredictable events such as conflicts, pandemics, etc. Generally, a trade cycle is composed of
four distinct phases; boom phase, recession phase, depression phase and recovery phase. Trade
cycles are asymmetrical, cumulative and international in character.
Figure 1. Boom in trade cycle (Adapted from
https://www.economicshelp.org/blog/glossary/booms/)
A boom is a period of rapid economic expansion resulting in higher GDP, lower unemployme nt,
a higher inflation rate and rising asset prices. Booms usually suggest the economy is overheating
creating a positive output gap and inflationary pressures. The boom, also known as the expansion
phase of the trade cycle is characterized by increasing economic factors, such as production,
employment, output, wages, product demand and supply, profits, etc. and a rise in the standard of
living (Ahuja, 2015). Businesses are able to balance their cash flows and there are increased
investment opportunities. When profit expectations of businessmen are good, large investment is
undertaken which causes aggregate demand to rise and bring about conditions of boom and
prosperity in the economy. Prices of output and the factors of production increase simultaneous ly.
So, producers keep on increasing their investment. Furthermore, when the economy is booming,
retail firms would like to hold more inventories so that the goods they are selling may not go out
of stock and their customers went away disappointed. In boom periods both output and
employment are at high levels, whereas in recession periods both output and employment fall and
as a consequence large unemployment come to exist in the economy. Investment demand is thus
highly volatile and causes recession or depression when it falls, and boom and prosperity when it
increases significantly.

Consumption
Consumption means the direct and final use of goods and services in the satisfaction of human
wants. Neoclassical (mainstream) economists generally consider consumption to be the final
purpose of economic activity, and thus the level of consumption per person is viewed as a central
measure of an economy’s productive success. People may consume single- use goods such as
foodstuffs, fuel, etc. and durable-use goods such as tables, clothes, etc. The use of such goods is
called unproductive consumption because their consumption does not help in the production of
other goods. Similarly, the services of doctors, teachers, servants, mechanics, etc. are consumed
for satisfying human wants. The use of such services is called productive consumption because
they help in producing goods and services. Consumption is the dominant component of GNP. A
1% change in consumption is five times the size of a 1% change in investment (Hall, 1986).
Importance of consumption:
• Consumption is not only the beginning but also the end of all human economic activities.
• The consumption pattern of a person gives us knowledge of the standard of living of the person.
• Consumption is the source of production. Production increases with increase in consumption.
• In the formulation of certain economic principles such as the Law of Diminishing Marginal
Utility, the Law of Demand, the Consumer’s Surplus, etc.
• The Government formulates its economic policies on the basis of the consumption habits of the
people.
There are four theories of consumption. They are;
1. Absolute income hypothesis: The Keynesian theoretical consumption function is called the
absolute theory of consumption. Consumption spending is the positive function of the absolute
level of income that is, higher the level of current income, higher is the consumption demand and
vice versa.
2. Relative income hypothesis: This hypothesis was formulated by James Dusenberry which states
that the satisfaction (or utility) an individual derives from a given consumption level depends on
its relative magnitude in the society (e.g., relative to the average consumption) rather than its
absolute level.
3. Permanent Income Hypothesis: It is an economic theory about consumption, first developed by
Milton Friedman which states that changed in permanent income, rather than changes in temporary
income, are what drive the changes in a consumer’s consumption patterns.
4. Life-Cycle Hypothesis: Consumption patterns change during different staged of their lives.
Individual want to maintain stable lifestyles to work to build assets during working lives.

Convergent Cycle
Convergence refers to the tendency for per capita income to grow faster in lower income countries
than in higher income countries so that lower income countries are catching up over time. If the
growth of the poor is greater than the growth of rich then the gap between rich and poor will
decrease in time and this situation is called convergence whereas if the growth of the rich is greater
than the growth of poor then the gap between rich and poor will increase in time and this situatio n
is called divergence.
Reasons for convergence:
✓ Technology transfer: Developing countries do not have to reinvent the technologies and they
can adopt already developed technologies from rich and reinvent new technologies. This concept
is named as advantage of backwardness by Alexander Greschenkron.
✓ Similarity in factor accumulation: Since developed economies have higher physical and human
capital and according to the law of diminishing returns, they would expect low returns whereas
developing has lower capital and high stock of labor, investing here will lead to higher returns.
Developing countries have the potential to grow at a faster rate than developed countries because
diminishing returns (in particular, to capital) are not as strong as in capital-rich countries.
Types of convergence:
1. Absolute or unconditional convergence: If two countries have same growth rate, population
growth rate, production function, per capita capital and per capital output then the poor country
with low level income per capital tends to grow faster than rich country with high level of income.
The unconditional convergence (absolute convergence) implies that all countries or regions are
converging to a common steady state potential level of income
2. Conditional convergence: Even if countries differ in their saving rates, population growth rates
and production functions (due to unequal access to technology) they will converge to differe nt
steady state with different capital-labor ratios and different standards of living in the long run. The
conditional convergence implies that a country or a region is converging to its own steady state.
3. No convergence: The third possibility is no convergence. This means that the low-income
countries will never catch up over time. Therefore, living standards may even diverge due to
widening income gap; the rich getting richer and poor getting poorer.
Divergent cycle
Divergent trade cycles are the opposite of convergent trade cycle. They are characterized by short
period of quick growth and long period of gradual loss.

Kitchin Cycle
Kitchin cycle is a short business cycle of about 40 months discovered in the 1920s by Joseph
Kitchin. This cycle is believed to be accounted for by time lags in information movements affecting
the decision making of commercial firms. Firms react to the improvement of commercial situatio n
through the increase in output through the full employment of the extant fixed capital assets. As a
result, within a certain period of time (ranging between a few months and two years) the market
gets ‘flooded’ with commodities whose quantity becomes gradually excessive. The demand
declines, prices drop, the produced commodities get accumulated in inventories, which informs
entrepreneurs of the necessity to reduce output. However, this process takes some time. It takes
some time for the information that supply significantly exceeds demand to get to the business
people. As it takes entrepreneurs time to check this information and to make the decision to reduce
production, time is also necessary to materialize this decision (these are the time lags that generate
the Kitchin cycles). Another relevant time lag is the lag between the decision (causing the capital
assets to work well below the level of their full employment) and the decrease of the excessive
amounts of commodities accumulated in inventories. Yet, after this decrease takes place one can
observe the conditions for a new phase of growth of demand, prices, output, etc. For example, the
volume of oil production on tight oil formations in the US depends significantly on the dynamics
of the WTI oil price. About six months after the price change, drilling activity changes, and with
it the volume of production. These changes and their expectations are so significant that they
themselves affect the price of oil and hence the volume of production in the future. These
regularities are described in mathematical language by a differential extraction equation with a
retarded argument.
Trade/ Business Cycle
A trade cycle refers to fluctuations in economic activities specially in employment, output and
income, prices, profits etc. From a conceptual perspective, the business cycle is the upward and
downward movements of levels of GDP (gross domestic product) and refers to the period of
expansions and contractions in the level of economic activities (business fluctuations) around a
long-term growth trend.

Figure 1. Business Cycles:

The phases of a business cycle follow a wave-like pattern over time with regard to GDP, with
expansion leading to a peak and then followed by contraction. Features of a Trade Cycle: 1. A
business cycle is synchronic. When cyclical fluctuations start in one sector it spreads to other
sectors. 2. In a trade cycle, a period of prosperity is followed by a period of depression. Hence
trade cycle is a wave like movement. 3. The business cycle is not periodical. Some trade cycles
last for three or four years, while others last for six or eight or even more years.
References
https://www.economicsdiscussion.net/trade-cycle/trade-cycle- meaning- features-
andtheories/21071 https://courses.lumenlearning.com/baycollege- introbusiness/chapter/reading-
the-businesscycle-definition-and-phases/

Trough
• A trough, in economic terms, can refer to a stage in the business cycle where activity is bottoming,
or where prices are bottoming, before a rise. A trough is marked by conditions like higher
unemployment, layoffs, declining business sales and earnings, and lower credit availability.
• After the trough, recovery and expansion begin.
• The trough is the bottoming process of moving from contraction, or declining business activity,
to recovery, which is increasing business activity.

https://www.investopedia.com/terms/t/trough.asp
 ABM-06M-2022
Sabin Ghimire
Recession
Recession is a slowdown or a massive contraction in economic activities. A significant fall in
spending generally leads to a recession. This may be caused due to various events such as financ ia l
crisis, external trade shock, adverse supply shock, natural disasters (e.g., pandemic) etc. As the
growth in economic factors reaches its peak, a gradual decline in demand starts. The decline
becomes rapid and steady and this phase of decline is called recession. At the beginning of this
phase, supply of the product exceeds the demand and hence, producers' cost exceeds their profit.
Producers realize this loss when their inventories start piling up and they avoid any further
investment in production. There is a rise in liquidity preference while the economic factors are
decreasing. During recession phase, realized growth rate is still above the trend line and the
economy enjoys the period of prosperity. When the growth rate goes below the steady growth rate,
it marks the beginning of depression in the economy. A recession is a period of economic activity
that has slowed or stopped completely. A recession is usually preceded by a major drop in
consumer expenditure. Such a slowdown in economic activity might endure for several quarters,
thereby halting an economy’s expansion. Economic metrics such as GDP, business earnings,
employment, and so on collapse under such a situation
Such a slowdown in economic activities may last for some quarters thereby completely hampering
the growth of an economy. In such a situation, economic indicators such as GDP, corporate profits,
employments, etc., fall. This creates a mess in the entire economy. To tackle this, economies
generally react by loosening their monetary policies by infusing more money into the system, i.e.,
by increasing the money supply. Governments usually respond to recessions by adopting
expansionary macroeconomics policies, such as increasing money supply or increasing
government spending and decreasing taxation. The recession which hit the globe in 2008 is the
most recent example of a recession. In recent years, recessions have become less frequent and don't
last as long.
Since the Great Depression, governments around the world have adopted fiscal and monetary
policies to prevent a run-of-the-mill recession from becoming far worse. Some of these stabilizing
factors are automatic, such as unemployment insurance that puts money into the pockets of
employees who lost their jobs. Other measures require specific actions, such as cutting interest
rates to stimulate investment.

Recovery
Recovery is the rising phase of an economy after the phase of depression reaches its lowest level.
It is a self-correcting process of an economic system and correction is achieved through price
mechanism. Recovery is the process by which an economy returns to a state of normal economic
growth after experiencing a recession, contraction, or depression. In order to achieve economic
recovery, it is often necessary for the government to intervene in the economy through stimulus
spending or tax cuts. Natural forces, such as a strong increase in consumer demand, are also
necessary elements to help jump-start the economy and spur economic growth. The leading
indicators of recovery includes the stock index, unemployment rate, employment-population ratio
(EPR).
During the recovery period, the economy goes through a process of economic adaptation and
change to new circumstances, including the reasons that caused the recession in the first place, as
well as the new policies and regulations enacted by governments and central banks in reaction to
the recession.

During recession phase, the rate of fall in prices of factor of production is more than the rate of
reduction in prices of final products. So, some sort of profitability always exists there, which tend
to increase after the trough. At the beginning of the recovery phase, employment is limited with
lower wages. Gradually, there is an increase in rate of consumption thereby, leading to an increase
in demand of a product. Investment also rises gradually leading to an overall increase in
employment and income. In this phase, there is an improvement in margin of profit as the rent,
wages and interest do not rise in same proportion as prices. For all these reasons, economic
activities get accelerated. Businesses start increasing their inventories, consumers start buying
more and more of durable goods and variety items. As the growth rate reaches above the steady
growth rate, the phase of recovery is over and the economy once again enters the phase of
prosperity. And hence, a cycle is completed.

Depression
An economic depression is an occurrence wherein an economy is in a state of financial turmoil,
often the result of a period of negative activity based on the country’s Gross Domestic Product
(GDP)’s rate. It is a lot worse than a recession, with GDP falling significantly, and usually lasts
for many years.
Causes of an economic depression
An economic depression is primarily caused by worsening consumer confidence that leads to a
decrease in demand, eventually resulting in companies going out of business. When consumers
stop buying products and paying for services, companies need to make budget cuts, includ ing
employing fewer workers.
1. Stock market crash
The stock market is composed of stocks that investors own in public companies. Changes in
shareholdings can be a reflection of how an economy is doing. When the stock market crashes, it
can be an indication of investors’ declining confidence in the economy.
2. Decrease in manufacturing orders
A business flourishes on the demand for its products and services. When manufacturing orders
reflect a decline, especially for an extended period of time, it can lead to a recession and worse, to
an economic depression.
3. Control of prices and wages
Price controls happened once during the term of former U.S. President Richard Nixon when prices
kept going higher. Also, when wages are controlled by the government and companies are not
allowed to lower them, businesses may be forced to lay off employees to survive.
4. Deflation
Deflation is basically the lowering of consumer prices over time. It may seem like a good thing
because people can now afford to buy more commodities but underneath it is the fact that prices
are lowered because of a decline in demand, too.

5. Oil price hikes

How oil price hikes can cause a ripple effect on almost everything in the market is common
knowledge. When it happens, consumers lose their purchasing power, which can lead to a decline
in demand.
6. Loss of consumer confidence
When consumers are no longer confident in the economy, they will alter their spending habits and
eventually reduce the demand for goods and services.
Signs of an upcoming economic depression
1. Worsening unemployment rate:
A worsening unemployment rate is usually a common sign of an impending economic depression.
With high jobless numbers, consumers will lose their purchasing power and eventually lower
demand.
2. Rising inflation:
Inflation can be a good sign that demand is higher due to wage growth and a sturdy workforce.
However, too much inflation will discourage people from spending, and it can result in a lowered
demand for products and services.
3. Declining property sales:
In an ideal economic situation, consumer spending is usually high, including the sale of homes.
But when there is an impending economic depression, the sale of homes goes down, signaling
falling confidence in the economy.
4. Increasing credit card debt defaults
When credit card usage is high, it is usually a sign that people are spending, which is good for the
GDP. However, when debt defaults rise, it could mean that people are losing their ability to pay,
which signals an economic depression.

Ways to prevent another economic depression

1. Expansionary monetary policy
An expansionary monetary policy involves cutting interest rates to encourage
investment and borrowing. When interest rates are lower, consumers will enjoy
more value for their money and will be encouraged to spend more.
2. Expansionary fiscal policy

An expansionary fiscal policy means increasing government spending, reducing

taxes, or a combination of both. Tax reduction gives consumers disposable income
which, in turn, encourages spending.
3. Financial stability

Financial stability involves the government guaranteeing bank deposits, which promotes the
credibility of banks.

Sunspot Theory

Sun Spot Theory of Business Cycles was developed in 1875 by Stanley Jevons. This is one of the
oldest theories of business cycles. In this work, he attempted to relate business cycles with actual
sunspots. He reasoned that sunspots impact weather, which affects crop production. Changing crop
production could, in turn, be expected to cause changes in the overall economy. The connection
between solar sunspots and business cycles has widely been dismissed as statistically insignifica nt.
However, later economists adopted the term "sunspot" as a less technical way to refer to a random
variable that can induce variation in an economic model that does not result from any economic
fundamentals. These "sunspots" represent exogenous variables or external shocks that shape the
path of the economy not so much through their direct impact but because of the way people change
their behavior before they even happen.
Hence, the term "sunspots" in economics refers to extrinsic random variables that do not impact
economic outcomes but reflect something other than the basic fundamentals of an economy.
Sunspots in economic models often reflect social or psychological phenomena that influe nce
economic decisions beyond the fundamental factors, such as supply and demand conditio ns, prices,
and consumer preferences.
Sunspot equilibrium:
This concept was defined by David Cass and Karl Shell. In economics, a sunspot equilibrium is
an economic equilibrium where the market outcome or allocation of resources varies in a way
unrelated to economic fundamentals. In other words, the outcome depends on an "extrins ic "
random variable, meaning a random influence that matters only because people think it matters.

Multiplier

In economics, a multiplier broadly refers to an economic factor that, when increased or changed,
causes increases or changes in many other related economic variables. In terms of GDP, the
multiplier effect causes gains in total output to be greater than the change in spending that caused
it. In macroeconomics, a multiplier is a factor of proportionality that measures how much an
endogenous variable changes in response to a change in some exogenous variable. A multiplier is
simply a factor that amplifies or increase the base value of something else. A multiplier of 2x, for
instance, would double the base figure. A multiplier of 0.5x, on the other hand, would actually
reduce the base figure by half. For e.g., Investment multiplier is a measure of change in national
income as a result of change in investment. For example, national income increases by 300 crores
as a result of an increase in investment of 100 crores. Then the multiplier is 3.

Assumptions of multiplier
1. There is autonomous investment in the economy.
2. Marginal propensity to consume remains constant.
3. Consumption is a function of current income.
4. No time lag between receipts of income and its disposal in the form of consumption.
5. Net increase in investment.
6. Supply of consumer goods is always in the economy.
Features of multipliers
1. It is associated with change in investment.
2. Size of the multiplier depends on the size of mpc.
3. Multipliers work in both forward and backward directions.
4. Value of multipliers ranges from unity to infinity.
Uses of multiplier
1. Tool of analyzing growth planning, projecting, investment requirements.
2. Tools for achieving targeted growth rate, if mpc is given.
3. Tools for analyzing the fluctuation in the economy.
4. Important tool for analyzing impact of taxation, foreign trade on economy.
Limitations of multipliers
1. Multipliers depend on a large number of factors along with mpc.
2. Efficiency of production.
3. Regular investment.
4. Multiplier period.
5. Full employment ceiling.
6. Assumptions that goods and services are always available in adequate supply.
7. Goods and services cannot be produced in excess of their full employment level.

Balanced budget theorem

A balanced budget occurs when revenues are equal to or greater than total expenses. A budget can
be considered balanced after a full year of revenues and expenses have been incurred and recorded.
Proponents of a balanced budget argue that budget deficits burden future generations with debt.
The balanced-budget theorem states that a marginal increment of (real) public expenditures for
goods and services, balanced by an equal marginal increment of (real) taxes or other public
receipts, will yield an equal marginal increment of real income when supply conditions permit,
i.e., at less than full employment and in the presence of excess capacity (Bronfenbener, 1981).
This theorem is due primarily to the Norwegian economist Trygve Haavelmo, a generation ago.
Budget can be divided into three types:
a. Surplus budget (Tax > Government expenditure)
b. Deficit budget (Tax < Government expenditure)
c. Balanced budget (Tax = Government expenditure)
It means that a simultaneous increase in taxes and spending will always generate economic growth
equal to the change. The balanced budget theorem helps us to know what happens when the GDP
of a country increases to the amount of change in government expenditure if both changes in tax
and government expenditure are increased in the same amount (Chang, 1996; Brady, n.d.).
For balanced budget theorem,
ΔG=ΔT
We have balanced budget multiplier, (Kbm) = 1
Earlier we have,
Government Expenditure Multiplier (Kg) = ΔY/ΔG = 1/1-MPC
Tax Multiplier (Kt) = ΔY/ΔT = -MPC/1-MPC
Now we have,
Balanced budget multiplier (Kbm) = Government expenditure multiplier + Tax multiplier
(Bronfenbrenner, 1981)
=1/1-MPC + -MPC/1-MPC
=1-MPC/1-MPC
=1
Let us assume that ΔG = 100 Crores, ΔT = 100 Crores and MPC = 0.5

Then, the government expenditure multiplier (Kg) = 1/1-MPC = 2

ΔY/ΔG = 2
ΔY/100 = 2
ΔY = 200 Crores
Change in national income or GDP due to change in 100 Crore government expenditure is 200
crores.
Again,
Tax multiplier (Kt) = ΔY/ΔT
= -MPC/1-MPC
= -0.5/1-0.5
= -1
i.e., ΔY/ΔT = -1
or, ΔY = -1 x 100 = -100 crores
Hence due to increase in tax of 100 crore there is decrease in GDP or national income by 100
crores.
Balanced budget multiplier (Kbm) = Government expenditure multiplier + Tax multiplier = 200 –
100 =100 crores
Here, income get increased by 200 Crores due to government expenditure but reduced by 100
Crores due to tax, so the net increase in income is only 100 crores.
If the government applied the balanced budget multiplier and increase government expenditure
and tax in equal amount then the increase in GDP will be equal to change in governme nt
expenditure.